FED WAVERS AS THE WORLD GET THE SWEATS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Fed wavers as the world gets the sweats

By Richard Cookson

Published: August 17 2010 22:22

It may seem strange, at a time when Germany has notched up its fastest quarterly growth since unification – about 9 per cent at an annual rate – to worry about growth. But, apart from Germany and one or two other developed economies, growth concerns abound. Both the Bank of England and US Federal Reserve warned recently that growth in their countries is likely to disappoint, while Japan’s government said this week that the country’s growth rate collapsed in the second quarter.

A good way to interpret these slowing growth rates in the developed world is through a choice of metaphor; what my philosophy tutor many years ago called a thought experiment; and by considering what the Federal Reserve did not do last week.

Take the metaphor first. If you diagnosed the horrific financial crisis at the end of 2008 and early 2009 as a temporary depression, the prescription was clear: vast amounts of antidepressants in the form of the biggest fiscal and monetary stimulus the world has seen. Eventually the patient would feel cheerier and the world a brighter place. In time, it could be weaned off the medicine.

If, in contrast, you thought growth had been powered by an unsustainable rise in debt, then a different metaphor for the stimulus seems apposite: giving methadone to a heroin addict. The effects of the medication would be transitory and the patient would at some point have to go cold turkey.

We can reasonably say which metaphor is best by dint of a thought experiment that my philosophy tutor would have dubbed a “conditional counterfactual”. Had the stimulus worked like anti-depressants, you would by now have expected short rates, rate expectations and bond yields to have risen sharply. But rates look as though they will be stuck at close to nothing across the developed world for the foreseeable future. Bond yields did rise sharply for a while; of late, however, they have been dropping like a rock.

Not coincidentally, with the exception of the UK, inflation rates (and, increasingly, inflation expectations) in the developed world have also been falling, unemployment has remained close to multi-year highs and growth globally is sputtering badly.

This noxious cocktail brings us neatly to what the Fed did not do last week. Investors had hoped for more quantitative easing to loosen monetary policy further. That they thought it necessary speaks volumes about how much the patient had relapsed.

But by guaranteeing to invest the proceeds of maturing securities, the Fed has merely put monetary policy on hold, it has not eased it. The realisation of what the Fed did not do appears largely responsible for the subsequent wobbly performance of risky-asset markets; for yields on longer-dated bonds issued by governments still considered fairly riskless (an increasingly endangered species) falling still further; and for market-based measures of inflation expectations, still elevated compared with the end of 2008, dropping further.

There does not seem to be a consensus at the Fed – or any other central bank – for further monetary loosening via the printing press, either because central bankers do not think it yet necessary; or because they are worried about expanding their balance sheets further; or, in the case of the US, perhaps because they want to put pressure on Congress not to tighten fiscal policy (for now, at least) by allowing the Bush tax cuts to expire.

Yet if growth does continue to slow sharply, the Fed will surely ease policy further. It is already failing one of its two mandates: maximising employment. It is in severe danger of failing the other: keeping prices stable. Core inflation in the US is dropping fast.

The problem for investors is that they do not know when the Fed might pull that trigger. And since the medicine is powerful, the effects on asset markets are, in the short term at least, likely to be profound.

Those of a more bullish persuasion might argue that the Fed opened the door to more monetary stimulus by its actions last week. The more pessimistic fall into two camps. The first worries about the side-effects of these drugs (notably inflation), if administered in overly large doses. The second wonders how much worse things have to get before the Fed acts and whether, even if it does, the dose will be too timid. Perhaps all the Fed and other central banks can do when it comes to debt addiction, is to manage the worst symptoms of withdrawal.

The writer is global chief investment officer at Citi Private Bank

Copyright The Financial Times Limited 2010.