World markets are practically giddy in their expectation for a new round of easing by the US Federal Reserve. As the Financial Times noted Thursday morning, “the FTSE All-World index is up 0.8 percent to its best level since September 2008. The benchmark has climbed 14% in six weeks–a period in which traders’ risk appetite has risen with every hint that the US Federal Reserve stands ready to inject further liquidity into the economy.” Yes, it’s a whooped-up world market hoping for holiday cheer from the Fed. But when it happens, will the markets still be cheering?
Specifically, the November FOMC meeting is when, by all indications, the Fed will launch a new round of quantitative easing (QE2) to address the economy’s continued weakness. It’s not just GDP the Fed wants to goose, but also inflation–a message the Fed floated in the September FOMC minutes:
Inflation had declined since the start of the recession and most participants indicated that underlying inflation was at levels somewhat below those that they judged to be consistent with the Committee’s dual mandate for maximum employment and price stability.
This we-need-more-inflation sentiment was also confirmed in a recent speech by New York Fed President William Dudley. It will most likely translate into action in the form of purchasing $100 billion or so per month of U.S. Government bonds, as most Fed watchers see it. The financial markets anticipate all this and so investors’ risk appetite lately is pretty voracious. But when the easing does happen, due to the inconvenient truths of global economics, it may not all go as swimmingly as the markets think. Here’s how Goldman Sachs global economists Dominic Wilson and Stacy Carlson frame the problem:
The fact that Fed has said explicitly that it wants to see inflation higher and that it has laid the ground for fresh easing puts it on a very different course to that mapped out by many other central banks around the world.
That is, many central banks are starting to tighten, worried as they are about the possibility of destabilizing inflation down the road. But the Fed wants a bit of the inflation genie and so is moving the other way. Quantitative easing–i.e., printing money, which is what the Fed will effectively do with these purchases–will quickly translate into an even weaker dollar, which will be bad news for foreign central bankers in the developed world, who see their competitiveness slip. Put yourself in their shoes: They see themselves as fighting the good fight against inflation and they are about to get clobbered for it as their currencies rise. Given that China’s currency is pegged to the dollar, it’s a double dose of bad news for those beleaguered central bankers.
What will the world’s central bankers do? Some governments will surely accommodate the Fed and loosen their own monetary policies. Others will try to intervene in the currency markets in ways that do not result in more liquidity in their economy, but such maneuvers are imperfect. Some central banks may not play ball at all and there the options are less pleasant. Tariffs and other protectionist moves to protect local industries is one possible step if the political pressure grows intense.
In the U.S., as most see it, the next round of Fed’s asset purchases will help the U.S. employment numbers a bit, keep interest rates low and prevent the economy from slipping into the red.
But will investors embrace the Fed easing if the U.S. economy continues to muddle along and the global discussion is filled with tariff talk? Richard Cookson, chief investment strategist at Citi’s private bank, is warning his clients that the great market rally may succumb to some of these issues. Here is his summary thought to clients this week
Protectionism, currency wars and Fed that does less than the markets expect are, short-term anyway, the ingredients for a pretty noxious cocktail. So enjoy the rally while it lats: the risks, it seems to us, are rising.
