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Central bank promises clearly still work--so give me more promises this fall but please no concrete actions
09/07/2012 8:30 am EST
More of what Mario Draghi and the European Central Bank delivered on Thursday, September 6. Promises detailed and convincing enough to make the financial markets believe—and rally as they did on September 6—but no concrete action.
That’s my hope for central bank decisions in September.
Frankly it’s an attitude founded not so much on optimism that the global financial and economic crisis is about to fix itself as on a cynical calculation that the world’s leaders won’t be ready to act much before the end of the year. And I think the best strategy for getting to that point in the year without the current crisis getting significantly worse is lots of central bank promises and very little central bank action.
That way the Federal Reserve and the European Central Bank keep the hope of powerful central bank intervention alive—which props up the prices of financial assets and optimism about the economy.
And all promises and no actions doesn’t reveal the depressing truth: That central banks have used their powder, emptied their tool box, burnt all their fuel—and the likelihood that anything they actually can do at this point will significantly add to economic growth is just about nil.
I can think of two possible outcomes if the Federal Reserve and the European Central Bank summon up the last ounces of policy mojo that they have—and neither is good.
First, at a minimum and in the short term, if the central banks do actually act instead of just promising to act, all those shorts and bears who had moved out of the financial markets in August to avoid getting crushed if the Fed and the ECB did move would now be free to go negative again. That includes not just traders who might short equities, but bears who might want to bet against the bonds of Spain and Italy. If the central banks act in September, there’s no danger that they’ll move in October.
And that freedom to go negative could produce a return of the worse of the Spanish and Italian bond crises in relatively short order.
Second, more seriously and in the slightly longer term, if the central banks act and demonstrate that they can’t fix the European debt crisis or the global economic slowdown with a wave of their balance sheets, then we’ve taken away an important psychological support for the belief that the crisis and associated slowdown are going to get better soon. If the Fed does implement a new program on bond buying under the rubric of QE3 and it doesn’t work (unemployment stays stuck at July’s 8.3%, for example,) then how do we get out of this slough of slow growth in the United States? If the European Central Bank does start the program—promised on September 6--of unlimited buying of three-year and shorter Spanish and Italian bonds and the effort doesn’t reduce interest rates enough to get those economies moving again, then tell me why the 35-year-old unemployed Italian or Spaniard should think things will get better soon?
It would be up to global political leaders to act—and frankly I don’t see a window for that possibility until near the end of 2012.
Better the illusion of hope than no hope at all? You bet. The hope that the central banks could yet throw out a rescue line would buy governments and the global economy time to deleverage, time to regain confidence, time to put policies in work that might actually address issues such as productivity and unemployment. And I’ll explain how this might work at the end of this post.
Remember that “might,” however.
But first a survey of the odds for constructive non-action.
So far, so good.
On August 31, at the Kansas City Federal Reserve’s Jackson Hole conference Fed chairman Ben Bernanke laid out what the Fed could do and the circumstances under which the Fed might act—but did nothing.
On September 5, the day before the meeting of the board of governors of the European Central Bank, details of the European Central Bank’s plan leaked to Bloomberg news. That was in itself brilliant (and I suspect deliberate) since it created the impression that the bank was preparing to act. Draghi’s press conference after the meeting furthered that impression. He laid out such a clear and reassuring plan for action—the bank would buy relatively short-term Spanish and Italian debt; the bank would renounce any claims to seniority for its own bond holdings; the bank will take on new regulatory powers—that no one called out that this plan was nothing but a more detailed version of his promises of the summer.
And then the plan that Draghi actually delivered on September didn’t just avoid teeing up concrete actions to put those promises into motion but also included an absolute barrier to action.
- Yes, the central bank would buy unlimited quantities of Spanish and Italian government one- to three-year bonds, but only after the governments of those countries formally ask for such a rescue. Those governments haven’t done that, and have made statements ranging from “we see no need to do that right now” by Italy’s Mario Monti to “we have no need to do that” by Spain’s Mariano Rajoy. Both the Rajoy government in Spain and the Monti government in Italian suspect, rightly I think, that asking for a bond rescue with conditions that smell even faintly of the conditions imposed on Greece would be political suicide.
- Yes, the central bank would buy unlimited quantities of those bonds after the European Financial Stability Facility and the European Stability Mechanism had joined in the rescue (or as Rajoy insists on calling it “the loan,”) but the first is supposed to be going out of business and the second isn’t yet in place. In fact the European Stability Mechanism is in limbo until the German constitutional court rules on September 12 on the constitutionality of the fund. Until then the Bundestag can’t even vote to approve the European Stability Mechanism, and without the Germans this fund is going nowhere.
- And don’t even get me started on all the contradictions in Draghi’s talk of conditions. Yes, countries asking to get in on the bond buying would have to agree to budget and deficit rules, but expect that a European Central Bank loaded up on Spanish and Italian debt would pull the plug if a country broke the rules? Puleeze.
We’re not out of the woods yet, of course.
There’s the relatively remote possibility that the German constitutional court will actually find the permanent European bailout mechanism unconstitutional. That would provoke a true crisis—all promises would be quickly seen to be dead—and that might force the European Central Bank to act to contain a catastrophe.
There’s still the September 13 meeting of the Federal Reserve’s Open Market Committee. It is possible that U.S. economic numbers could take a turn from grim to grimmer in the next week so that the Fed would act. I think that’s unlikely after this week’s good news on U.S. auto sales—a 19.9% increase in August from August 2011—and so close to the November presidential election. I think the worst that we can expect from the Federal Reserve on September 13 is heightened rhetoric about the need to move if the economy gets worse.
And, of course, there’s the European agenda that includes a summit on October 18 and then another special summit on November 22. But nobody really expects anything but promises from a European summit, right?
The Federal Reserve’s Open Market Committee meets again on October 24 and on December 12.
I think there’s a very good chance that we’ll muddle through on a diet of promises and non-actions until December.
Is that good or bad? It depends.
If the promise of action—without the unmasking of action as ineffective—can keep Spanish bond yields from breaking much above the 7% to 7.25% range, I think we’ll get through the fall without a full-scale meltdown in the European bond markets.
If the U.S. economy picks up strength in the fall—and there are signs that it will (ranging from reports of strong back to school sales with a 5.9% increase in comparable store sales in August to those August auto sales numbers I mentioned earlier)—then we might actually get a financial market rally in the fall. Higher asset prices wouldn’t solve much—they would contribute to the recovery in the U.S. housing sector, it’s true—but a shot of animal spirits would temporarily at least boost economic growth as we head into the Christmas shopping season.
If growth in China looks like it is stabilizing in the fall—as opposed to heading for a hard landing—that would certainly have a positive effect on commodity prices and commodity economies. And it would remove a big worry from the financial markets.
The muddling through gets harder after that.
Over all this looms the U.S. fiscal cliff. Depending on how the election goes in November (and by that I don’t mean which party wins so much as I mean what conclusions they draw from the results about where political advantage lies), I can see the United States skirting disaster with a last-minute compromise or pulling a Thelma and Louise and heading right into the canyon.
It’s too early to say “Buy gold and bury it in the backyard,” but December could be very dangerous.
Promises instead of actions—my wish for the next few months--would probably be relatively effective in stabilizing the financial markets in the fall, but it would do nothing to actually address the problems in the world’s real economies. Muddling through is really a hope that the world’s economies will somehow fix themselves. I think that’s possible in the United States and China for a while. Unlikely in the EuroZone. And I’m not hopeful that the “for a while” would last very long.
The major downside of my hope for promises and not action is that while it does buy time for leaders to come up with policies to fix global economies, the pattern of promising rather than acting that characterizes this crisis pretty much guarantees that we won’t use the time gained very effectively.
And there is a good chance that as long as the central banks haven’t shot their last arrows, our political leaders won’t feel compelled to come up with their own solutions. You could make an argument that the big advantage of actions that show the central banks are out of ammunition now would be that political leaders would be more likely to move sooner.
You could make that argument. But I won’t. I don’t think U.S. politicians will move to action until the November election is done. China’s leadership is in the midst of its own transition that is part of the reason for the relatively low-key response to China’s economic slowdown. That transition won’t be completed until the meeting of the National Party Congress in October.
So my argument would be that it would be best if we can muddle through into November or December on promises while keeping the last moves from the world’s central banks in reserve. We’re more likely to get effective action from global leaders toward the end of the year than now. But since it is by no means certain that we will, I’d rather head into the end of the year with what limited firepower central banks have still in hand rather than squandered as a wet squib in the next few weeks.
I think avoiding a return to the darker days of this crisis is going to be a near thing. And the best way to avoid that pain is to promise loudly this fall and do nothing.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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