LONDON (Reuters) – “Market participants should not direct policy,” Kansas City Fed President Thomas Hoenig warned listeners at a town hall meeting in Lincoln, Nebraska, back in August. Unfortunately that is precisely what is now happening.

Hoenig noted that Wall Street’s clamour for cheap money was not disinterested: “Of course the market wants zero rates to continue indefinitely … they are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.”

Now the same pressure groups want the Fed to launch a second round of asset purchases so they can sell U.S. Treasury bonds to the central bank (in effect back to the federal government) at inflated prices.

A new round of securities purchases provides investors with an exit strategy from what might otherwise be a dangerous bubble in the bond market. Every bubble needs a “greater fool” prepared to pay a higher price for the asset to keep the bubble inflating. In this case, the guaranteed sucker is the Fed itself.

Meanwhile quantitative easing (QE) has pushed up the value of all the risk assets institutions and investors hold, giving the market a highly desirable insurance policy.

Set aside the question of whether the Fed should socialise investors’ risks and losses in this way. Set aside also the issue of moral hazard — whether by bailing out investors the Fed will encourage more excessive risk-taking behaviour in future. Most officials admit recent actions have increased moral hazard but believe it is a problem to be solved in the long term by appropriate supervision.

The immediate policy question is whether the prospective QE programme is contributing to stability in the financial markets and an environment likely to encourage more long-term investment by businesses and job creation. In other words, is QE succeeding in its own terms, meeting the objectives set by the central banks themselves?

LONDON (Reuters) – President John F Kennedy popularised the aphorism that “a rising tide lifts all boats” but he might have noted that it does not lift them all equally.

The same is true of quantitative easing. Prospects for another round of securities purchases have lifted prices for a broad spectrum of assets. Not just medium-term Treasury notes the Fed is thought likely to buy but corporate bonds (that are near substitutes) and riskier assets (such as commodities and equities).

The Fed terms the mechanism by which bond purchases force investors to change the composition of their portfolio and hold more high-risk assets, spurring private sector borrowing and investment, the “portfolio balance effect.”

The problem is that injecting liquidity does not affect all asset prices evenly.

In the face of high levels of uncertainty about the outlook (inflation, deflation, expansion or a double dip?) and the Fed’s policy response (how much QE and for how long?) there is good reason to believe investors will prefer highly liquid financial assets (bonds, equities, currencies and commodity derivatives) to less liquid ones (buildings, equipment and software). Liquid assets provide a safer exit strategy if expectations turn out to be incorrect.

Among the constellation of liquid assets, uncertainty and fear about mounting monetary and price instability seem likely to steer investors towards those companies, countries and commodities thought to have the most pricing power, with the fewest competitors and suffering the least over-capacity. Only once opportunities in these companies, countries and commodities are saturated are investors likely to show strong interest in value sectors with more surplus capacity.

COMMODITY DIFFERENTIATION

LONDON (Reuters) – In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that “there is no such thing as society”, only individual men and women, and families.

The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.

But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of “society” to the individuals behind it.

The distinction between aggregates and individual components is something the Federal Reserve should bear in mind as officials mull whether to launch a new round of asset purchases to keep inflation from falling further and stimulate the recovery.

Because in some sense there is no such thing as inflation, only a collection of price rises for individual items, some rising faster and some slower.

It is clear price increases do have a structural component. Policymakers and economists distinguish between a general rise in the level of prices (“inflation”) and relative price increases for individual items (Adam Smith’s “invisible hand” guiding the reallocation of scarce resources).

But in an economy characterised by uneven spare capacity, with bottlenecks in some areas and unused capacity in others, excess demand and inflationary pressures may not show up evenly. Even as all prices rise (inflation), price rises are likely to be largest in those parts of the system with the worst bottlenecks, while increases in areas suffering significant under-employment of resources lag behind.

LONDON (Reuters) – Chairman Ben Bernanke’s Fed is beset by demons of its own design.

Terrified by memories of the 1930s and Japan’s more recent experience in 1990s and 2000s, the academics who now dominate the Federal Open Market Committee display a hyperactive compulsion to tinker with monetary policy in a bid to solve all the problems besetting the U.S. economy.

But if inflation is always and everywhere a monetary phenomenon, as Milton Friedman argued, Fed policy has a smaller role in solving real-economy problems such as a gaping trade deficit, moribund housing market, sluggish growth and joblessness.

Expectations of another substantial round of quantitative easing (QE2) have gone too far for the Fed to pull back now. The Fed must press ahead or risk a massive, disorderly correction across all asset classes (bonds, equities, commodities and currencies).

But once the trigger is pulled members of the FOMC should resist the temptation to tweak further and give the normal cyclical processes of recovery and structural reforms time to work.

HUBRIS

Never before has the Fed had so much theoretical firepower at senior level.

LONDON (Reuters) – Get your excuses in early seems to be the strategy for members of the Bank of England’s Monetary Policy Committee (MPC) fearful of an outpouring of public anger about failing to control inflation, avert a double-dip recession, or perhaps both.

Speaking in Dublin on Tuesday, MPC Member David Miles admitted: “It is a near certainty that four or five years from now the monetary policy that is set over the next year will, with the benefit of hindsight, look very likely to have been too loose or too tight. Many will then talk about the big mistake the MPC made in late 2010 and the first part of 2011.”

“If we tighten too quickly it will be a story of myopic MPC learnt nothing from events of 2008; if growth and inflation look stronger than I now think is the most likely outcome it will be MPC completely failed to see what was obvious to nearly everyone — that inflation was out of control.”

Miles echoed a pre-emptive “mea culpa” issued on Sep. 22 by Bank Chief Economist Spencer Dale who acknowledged: “It is quite likely that in hindsight, once we see how the economy evolved and which risks materialised, that the current stance of policy will be criticised for having been too tight or too loose”.

The Bank’s increasing defensiveness reflects both its intellectual embarrassment at failing to meet the inflation target (42 months out of the last 51, and counting) and growing criticism and scepticism of its strategy. It is not just the committee members but the Bank as an institution and the system of inflation targeting that is now in the firing line.

The Bank knows that within the next year attacks are likely to intensify if inflation remains above 3 percent (equal to its 2 percent target plus the expected impact of the forthcoming VAT rise) or the economy slides back into recession as a result of the government’s austerity programme (with which Bank Governor Mervyn King is closely identified).

Pre-emptive excuses are designed to head off calls for wholesale reform of the system (“new men, new measures”). It lays the groundwork for arguing that the Bank could not have done better in exceptionally difficult circumstances, and should be given another chance to prove it can make the inflation target work, once the crisis and its aftermath have passed.

LONDON (Reuters) – In Greek mythology, when Pandora opened her jar the ills of the world sprang out, leaving only hope behind. Once out, the contents could not be captured and put back. Pandora could not undo what she had wrought.

In 2008-2009, central banks billed their strategy of ultra-low interest rates and quantitative easing as extraordinary and temporary measures — justified by the exceptional severity of the banking crisis and the danger to the global trade and payments systems.

But what was once unconventional and unorthodox is rapidly becoming the new normal and likely to be maintained for an extended period.

In theory, the main central banks are still committed to reverting to pre-crisis system of inflation targets and an orthodox monetary policy centred on short-term interest rates.

But it will not be easy to exit from the extraordinary interventions of the last two years or persuade investors, policymakers and the public that central banks should revert to a more limited role focused on core consumer prices and short-term rates, leaving broader trends in debt, equity and commodities to market forces.

TECHNICAL STEP, OR REVOLUTION?

Most central bankers and economists still characterise ultra-low rates and quantitative easing (QE) as a crisis response or an extreme version of traditional monetary policies.