MacroScope

It’s raining central bankers today which is well-timed after Federal Reserve Chairman Ben Bernanke dropped the bombshell that the Fed could take the decision to begin throttling back its money-printing programme at one of its next few policy meetings. If that’s the case, and it’s not yet a done deal, then it will be the Fed that will move first in that direction, presumably putting further upward pressure on the dollar and send financial markets into something of a spin.

European stock futures look set to open sharply lower – 1.5 percent or more down – buffeted by suggestions that the Fed could soon change tack. Safe haven German Bund futures have opened higher for the same reason, though in a much more measured fashion. One of Bernanke’s colleagues, James Bullard, speaks in London today. Another, Charles Evans, is in Paris.

The European Central Bank has never got into the realms of QE but it did produce the single most important intervention over the past three years. Ten months after his pledge to save the euro fundamentally changed the dynamics of the currency bloc’s debt crisis, ECB chief Mario Draghi returns to the scene of his game-changing promise – London – to deliver a keynote speech. Draghi does not speak until the evening but his colleagues – Weidmann, Noyer, Coeure, Liikanen and Nowotny – all break cover earlier in the day. Draghi has said the ECB is prepared to act further if the economy worsens, having already cut interest rates to a fresh record low this month and ECB chief economist Peter Praet said last night that its toolkit could be expanded if necessary. But what?

The ECB’s bond-buying plans are dormant because no country needs the help at the moment and there is no talk of a repeat of last year’s 1 trillion euro splurge of cheap long-term liquidity to banks. There is talk of cutting the deposit rate – the rate banks get for parking funds at the ECB – into negative territory to try and get them to lend. But will that do much? Despite being in a world awash with central bank money and stock markets in the ascendant, the fact that safe haven bond markets such as Bunds and U.S. Treasuries haven’t sold off much denotes ongoing nervousness among banks and investors.

Flash PMIs for the euro zone, Germany and France for May follow first quarter GDP data which showed Europe’s largest economy just about eked out some growth but nobody else in the currency bloc did. That trend is likely to be reaffirmed with a harsh winter, having curbed German activity in Q1, allowing for a rebound in sectors like construction in Q2. France and the rest of the pack are unlikely to be so lucky. China’s PMI has show factory activity shrank for the first time in seven months so the global vista looks sour again.

We heard it more than once at today’s hearing of the Joint Economic Committee featuring Fed Chairman Ben Bernanke: the central bank’s low interest rate policies are allowing Congress to delay tough decisions on long-term spending.

As U.S. senator Dan Coats asked pointedly: “Is the Fed being an enabler for an addiction Congress can’t overcome?”

Yet, if you read the subtext of Bernanke’s testimony closely, it may actually be Congress that is enabling a loose Federal Reserve.

The Federal Reserve has a long list of worries about the unexpected consequences of its quantitative easing (QE) program. There’s the risk that all the bond-buying is quietly stoking bubbles in disparate asset classes, and the lingering risk of a future run-up in inflation, and even the political risk of balance sheet losses down the road. But above all, what really keeps Fed policymakers up at night might be their most immediate concern: that investors will overreact when they finally decide to reduce the $85-billion monthly pace of asset purchases.

In perhaps the starkest words yet from someone in Fed Chairman Ben Bernanke’s inner circle, here’s what New York Fed President William Dudley said about this in a speech to the Japan Society in New York on Tuesday:

There is a risk that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month. Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.

The British government faces another potentially thorny day with the International Monetary Fund delivering its annual review of the UK economy. If David Cameron has a consistent policy, it’s that the only way to get Britain back on its feet is to cut spending and debt. Trouble is, we know the IMF doesn’t agree and advocates a more growth-fostering approach. Finance minister George Osborne has changed rhetorical tack in response but is walking a tightrope as a result.

This comes at a time when there are distinct signs that Cameron’s Conservative party is unraveling and not just over Europe. Unless he gets a grip soon, who knows what further concessions may be made on an EU referendum which could push Britain further towards the exit door. It remains unlikely that the coalition government will fall apart before 2015 elections, not least because the junior, pro-EU Liberal Democrat partners face electoral evisceration according to the polls. It’s even less likely that Cameron will be toppled by fractious members of his party. But it’s no longer impossible.

Britain’s LibDem deputy prime minister will take the unusual step of holding a news conference to say the coalition will hold together until 2015. Another big flashpoint looms this summer with the government’s spending review where hardline Conservatives will push for big welfare cuts and the LibDems will resist. Former foreign secretary Geoffrey Howe, the man who did more than anyone else to end Margaret Thatcher’s reign, says Cameron is losing control of his party. From the other side of the political divide, Peter Mandelson says he has to lead not follow. Hard to argue with either of them.

Financial markets this will be keenly focused on congressional testimony from Fed Chairman Ben Bernanke and minutes from the central bank’s April 30-May 1 meeting, particularly given a thin data calendar. The latter may be the more interesting one, since it will offer hints into how far Fed officials are leaning in a direction of curbing the pace of its bond-buying stimulus, potentially late this summer.

The economic backdrop has been just mixed enough to leave policymakers cautious about taking their foot off the gas. Still, if we get a few more months of strength in the labor market, Fed officials may just be able to say “substantial progress” has been made in the outlook for the labor market – their stated precondition for an end to asset buys.

Still, Harm Bandholz at Unicredit says markets should not confuse a debate about tapering bond buys with some immediate reversal of the Fed’s policy of ultra low rates.

It looks like a week short of blockbusters, particularly today with much of Europe on holiday. But there will be plenty to chew over over the next few days on the state of the euro zone and whether newly-printed central bank money lapping round the world risks throwing things off kilter.

Flash PMIs for the euro zone, Germany and France for May, plus the German Ifo index, follow first quarter GDP data which showed Europe’s largest economy just about eked out some growth but nobody else in the currency bloc did. That trend is likely to be reaffirmed with the harsh winter, having curbed German activity in Q1, allowing for a rebound in sectors like construction in Q2. France and the rest of the pack are unlikely to be so lucky.

For the markets, this leaves all sorts of assets in demand since if the economy worsens, central bank largesse will stay in place for longer and could be enhanced and if recovery finally shows up, well then that’s good for stock markets at least. The only real losers so far have been in the commodities and energy arena. The 500-pound gorilla in the room is how the world economy will cope when the big central banks finally halt and even start to reverse their extraordinary stimulus policies but that looks like a question for 2014 at the earliest. Interestingly, both the IMF and Bank for International Settlements issued warnings about this on the same day.

Ann Saphir contributed to this post

Minneapolis Federal Reserve President Narayana Kocherlakota has gone from being one of the U.S. central bank’s more hawkish characters to arguably its most dovish. In line with this transformation, Kocherlakota told a conference sponsored by the University of Chicago’s Booth School of Business that the Fed, despite its extensive bond-buying over the last few years, has not done enough to spur growth.

The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

To get a sense of what he means, see the graphs below: U.S. inflation continues to undershoot the Fed’s 2 percent target, and is actually drifting lower, while unemployment, though down from crisis peaks, remains stubbornly high.

Here are comments from a U.S. Treasury official on Secretary Jack Lew’s meeting with incoming Acting IRS Commissioner Daniel Werfel this morning, following a scandal of political targeting that cost the previous acting commissioner his job. Treasury officials knew about the problem as early as last June, according to this report in the Wall Street Journal:

Secretary Lew met with incoming Acting IRS Commissioner Werfel this morning and directed him to conduct a thorough review of the organization in an effort to restore public confidence in the IRS and ensure the organization is providing excellent and unbiased service to the taxpayer. Secretary Lew also requested that he take actions immediately as appropriate, and that within the next 30 days, Werfel report back to the President and him about progress made in three areas: 1) ensuring staff that acted inappropriately are held accountable 2) examine and correct any failures in the system that allowed this behavior to happen and 3) take a forward-looking systemic view at the agency’s organization.

Spanish government bonds have had a good run since the European Central Bank said it would protect the euro last year. But some analysts say the threat of a rating downgrade to junk remains an important risk.

Credit default swap prices are discounting such a move, according to Markit. Spain is only one notch above junk according to Moody’s and Standard & Poor’s ratings, and two notches above junk for Fitch. All three have it on negative outlook.  Bank of America-Merrill Lynch says it sees a “high probability” of a sovereign rating downgrade in the second half of the year.

As the table above shows, a cut to sub-investment grade would prompt Spanish sovereign debt to fall out of certain indices tracked by bond funds, resulting in forced selling, which could drive Spanish borrowing costs higher.

In the barrage of Federal Reserve speakers making the rounds on Thursday, it is notable that San Francisco Fed President John Williams was the one that managed to move markets, allowing the dollar to recover losses. Why did his voice rise above the din? For one thing, he’s seen as a dovish-leaning centrist whose views closely resemble the Bernanke-Yellen core of the central bank.

Plus, he took the oft-abused economy-car analogy in a, er, new direction:

If we were in a car, you might say we’re motoring along, but well under the speed limit. The fact that we’re cruising at a moderate speed instead of still stuck in the ditch is due in part to the Federal Reserve’s unprecedented efforts to keep interest rates low. We may not be getting there as fast as we’d like, but we’re definitely moving in the right direction.