Quantitative Tightening

The emerging market economies of the world are taking tightening steps, in part to offset the effects of the U.S. Fed's "quantitative easing".  Yesterday Australia raised interest rates by 1/4% to 4.75%.  Australia is widely viewed as a proxy for China given their commodities exports to the Chinese.  India has also raised rates with their central bank rate for short-term funds now at 6.25%.

These countries are worried about capital flows from the U.S. (and other developed markets) being enhanced by the increased liquidity from the anticipated next step of  Fed quantitative easing.  As capital flows to the emerging markets it will cause inflationary increases in all goods.  Increased interest rates and increases in their currency relative to the U.S. are two ways these emerging economies can fight inflation.

All of this reminds us that the effects of any market or policy changes are global.  The key for investors is to keep this global point of view in mind as they make portfolio decisions.

Deflation concerns at the Fed

In their release after meeting on Tuesday, August 10, the Federal Reserve Open Market Committee (FOMC) indicated they would now begin to purchase long-term Treasury bonds with the maturity proceeds of the approximately $1.3 trillion of mortgage-backed securities the Fed purchased during the 2008-2009 credit crisis.  Prior to this FOMC decision, the Fed plan was to let the mortgage-backed securities just roll off as they matured and gradually remove that stimulus.  The Fed made clear their concerns in their published statement after the meeting with language of "the pace of recovery in output and employment has slowed in recent months".

The fear now seems to be the possibility of Japanese-style deflation, with the U.S. 10-year Treasury now yielding 2.8% as compared to a 2010 rate peak of about 4% in April.  Note that even at 2.8% U.S. rates are 1.7% above comparable government securities in Japan, so there is still far to travel to reach those levels.  Further, in Japan the average monthly inflation since end of 1992 has been minus 0.1%, while in the U.S. the June 2010 data showed annual core CPI (excluding food and energy) of 1%, so we still aren't seeing U.S. deflation.

It is comforting to some that the Fed is tuned into slowing growth and deflation risks.  Others see the Fed as ineffective as they can't force monetary stimulus into a banking system where credit standards have tightened and loan demand declined.  Still others see the Fed actions to fight possible deflation in the short-term as leading to U.S. dollar currency devaluation and inflation in the long-term.  No one can clearly see where this is all going and investors have to be careful not to be whipsawed as the markets react to the latest news and government policy actions.

Deflation or inflation: Which poses the greatest risk?

The U.S. Federal Open Market Committee meets next week to discuss policy and they will likely be debating the question posed in this blog headline.  The potential of a policy mistake would seem to be rising.  Tighten too soon and the Fed could push the U.S. towards another dip into recession.  Wait too long (or be too loose with stimulus) and the seeds for future inflation could be sown broadly and deeply.

Many experts have said that while there is no concern about inflation in the next year or two, they expect the Fed to err in the direction of avoiding deflation, raising the prospect of higher inflation in the long term.  This makes good sense to us, but time will tell.

The important thing to recognize is that the chances of a policy mistake and the ultimate effects of such a mistake on both the economy and the markets are on the rise.

Why the U.S. will never be another Greece

Greece is in the headlines recently as the interest rates on Greek government bonds have risen sharply due to their fiscal problems.  Greece is part of the European Union (EU) and the level of Greek sovereign debt as compared to GDP and the annual deficits as compared to GDP are well in excess of EU guidelines for its member countries.  Remember though the currency for Greece is the Euro, meaning Greece can't simply issue more currency to inflate their way out of their fiscal and debt problems.  There is the chance that Greece could default on its debt if it doesn't get some help from stronger European Union members like Germany.

The United States is a different story.  Since the U.S. controls its own currency, there would never be a default on a Treasury bond.  If the U.S. was in dire financial straits similar to Greece, we could (and in our opinion would) simply print more dollars to pay our fixed debt obligations.  The result, reductions in the value of the dollar as compared to other world currencies and gold accompanied by inflation.  This, we believe, is the long-term risk of excess U.S. deficits and growing debt.  For those looking several years down the road, now may be the time to begin hedging against the possibility of such inflation and dollar declines