QEII sails, Fed mandate at helm Worldly Wise

When central bankers start protesting that inflation is too low, you can be pretty sure they're gearing up to do something about it.

That was the take-away from the Federal Reserve's post-meeting statement last month.

The invocation of its dual mandate convinced folks another round of quantitative easing was a done deal.

"Measures of underlying inflation are currently at levels somewhat below those the committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability," the Fed said in its September 21 statement.

Translation: It's not that we want to blow up our $2.3 trillion (Dh8.4 trillion) balance sheet any further. We are compelled to by law; specifically, by the 1977 amendment to the Federal Reserve Act.

Prices, at least prices as measured by the consumer price index, are relatively stable.

The CPI and the core index, which excludes food and energy, rose 1.1 per cent and 0.9 per cent, respectively, in the year through August. The six-month annualised increases are 0.5 per cent and 1 per cent.

That may look stable to you and me, but it's below what the Fed claims is "consistent with stable prices," which is another way of saying "too low for our comfort level."

Employment is hardly maximum. The monthly increase in private payrolls has averaged 95,000 in the first eight months of the year, not nearly enough to put a dent in the unemployment rate, which is stable, at an uncomfortably high 9.6 per cent.

Positive reinforcement

Economists listened to Fed chief Ben Bernanke invoke the dual mandate at Jackson Hole, Wyoming, in August; they read Jon Hilsenrath's recent pieces in the Wall Street Journal; and they digested the September 21 statement before predicting that QEII would set sail after the Fed's November 2 to 3 meeting, which happens to conclude one day after the midterm election.

Friday, New York Fed President Bill Dudley reinforced that expectation, saying the onus was on the economic data to prevent the central bank from moving ahead with its bond purchases.

While stocks and bonds have been savouring the benefits of QEII, the message from currency and commodity markets is altogether different. The dollar has been sinking while gold sets new highs almost daily. Commodities overall have embarked on a bull run, just as in late 1993, when a jobless recovery finally kicked into gear.

If deflation, that is, persistent, 1930's like deflation; not a CPI decline of 1 per cent, were a threat, you would think folks would want to hold the currency, which buys more when prices fall. Instead, the currency market is forewarning of too many dollars in circulation.

Financial stocks have lagged the broader market as well, a combination of regulatory uncertainty, low trading volume and most recently, a flatter yield curve as prospects for Fed bond- buying have increased. (Traditionally banks' motto has been borrow short, lend long.)

Something keeps gnawing at me. Fed policy makers, looking at coincident economic indicators released with a lag, are afraid the US could succumb to a bout of Japanese-style deflation: slight but persistent declines.

Investors in stocks and bonds are happy to go along, having been trained not to fight the Fed.

Currency markets are conveying a different message: that the dollar isn't worth holding (except to buy US Treasuries) because it will lose its value in the future.

Whom to trust?

Call me a contrarian, but I keep wondering if the Fed's embarkation on QEII won't somehow mark the beginning of something better for the US economy. Not because of it but coincident to it. Based on the Fed's history of being late to the party.

Bank credit rose in July and August after 16 consecutive monthly declines. M2, the Fed's broad monetary aggregate, is growing modestly (at least it's not contracting). A Republican takeover of the US House of Representatives could assuage the business community. And an economy's natural tendency is to grow, even in the face of hurdles.

The US faces huge, long-term structural problems. The government has made promises to retirees it can't keep short of imposing confiscatory levels of taxation. Politicians in Washington fiddle while Rome burns. Persistent long-term unemployment is sapping the nation's spirit.

It's too depressing to contemplate. Even if the Fed embarks on QEII, it won't be smooth sailing for the ship of state.