ON THE ROAD TO REFLATION / BARRON´S MAGAZINE ( HIGHLY RECOMMENDED READING )

.
Up and Down Wall Street

THURSDAY, DECEMBER 1, 2011

On the Road to Reflation

By RANDALL W. FORSYTH

After Fed-led swaps rate cut and moves by China and Brazil, focus shifts to key EU summit.

.
Eight of the world's major central banks sent a strong, unequivocal signal to global markets Wednesday that they will do anything and everything in their power to prevent another financial meltdown and the risk of a renewed global economic contraction.

The Federal Reserve, in conjunction with the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Japan and the Bank of Canada, slashed the cost of dollars provided through the Fed's dollar swap facilities to ease the funding crisis faced by European banks as a result of the eurozone sovereign debt crisis.
.
That coordinated action of these developed economies' monetary authorities got most of the credit for the explosive rally in risk assets that sent the Dow Jones Industrial Average soaring nearly 500 points. But the moves by two of the major emerging economies -- China and Brazil, or half of the BRICs -- should not be overlooked.
.
The central bank of China, now the world's second-biggest economy, lowered banks' reserve requirement ratio by one-half percentage point, which marked the beginning of the unwinding of its tightening campaign to cool its formerly overheating economy and curb inflation. The effect on the former became evident early Thursday with the release of China's purchasing managers index, which dropped below 50, denoting contracting activity, for the first time in three years.
.
Late Wednesday, Brazil's central bank lowered its key policy interest rate by 50 basis points (one-half percentage point) for the third straight months. Policy makers there again said the rate reductions could mitigate the effects of the slowing global economy while inflation moves down to their target in 2012.
.
Strictly speaking, the Fed's easing of terms of credit for dollars provided to other central banks is a narrow, micro action. But, writes Goldman Sachs economist Zach Pandl, these swaps were an "unsung hero" in the financial crisis that played an important role in stabilizing bank funding costs. Those expenses have risen steadily for European banks as the crisis in the European bond markets deepened, sending yields sharply higher and pushing prices of their securities holdings down.
.
Adds BCA Research's U.S. Bond Strategy Weekly report, the sum of the actions of all these central banks "represents a significant step on the road toward global reflation."
.
Once again, the focus turns to Europe and its policy makers. Next Thursday, the ECB holds a regularly scheduled meeting to set interest rates. At the previous meeting, the ECB surprised with a 25-basis-point cut, a small but symbolically significant move for the new bank head, Mario Draghi, to begin reversing the excessively tight policy of his predecessor, Jean-Claude Trichet. This time, there may be more forceful action, including possible bigger rate reductions and more aggressive liquidity provision to European banks.
..
The next day will bring yet another European Union summit. German Chancellor Angela Merkel is expected to push for tighter central fiscal oversight of eurozone member budgets, including possible penalties for failure to comply with deficit targets. That could be a quid pro quo for expanded ECB purchases of bonds of beleaguered sovereign debtors such as Italy and Spain in order to cap their borrowing costs.
.
Then on Dec. 13, the Federal Open Market Committee holds a regular policy meeting, at which time the status quo likely will be reaffirmed. That would consist of maintaining the FOMC's intention to hold the its federal-funds rate target near zero through mid-2013 and continuing its so-called Operation Twist consisting of selling short-term Treasury securities and buying longer-dated ones and reinvesting principal payments on agency debt and mortgage-backed securities in MBS.
.
"More aggressive action by the Fed may yet be necessary," according to BCA U.S. Bond Strategy Weekly. That would likely depend on inflation expectations and asset-price stability. The first two rounds of quantitative easing (outright Treasury securities purchases) and Operation Twist followed drops in inflation expectations and asset prices, it notes. QE can be effective in supporting risk assets and inflation expectations, it continues, although merely extending maturities probably will be much less effective.

Employment trends also are important, though it would take three months of payroll increases of less than 50,000 per month to get the Fed to ease further, BCA adds. Given the 206,000 jump in private payrolls recorded by ADP for November, that seems unlikely for Friday's employment report. The consensus guess among economists is for a 125,000 rise in total payrolls in November, up from 80,000 reported for October, and the jobless rate to remain at 9%.
.
The employment report, usually a key number for the markets, will likely be overshadowed by action in Europe and the markets. Moves by central banks Wednesday have given markets encouragement that a crisis will be staved off. It remains to be seen if the EU leaders take sufficiently decisive action to solve the crisis in the eurozone.