Sent: 09-03-2011 12:00:43
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In the Hands of the Central Bankers
Investment success is depending increasingly on the skill of central bankers as finer judgments about economic conditions are required.
In 2008 when the world seemed to be hurtling unrestrained toward an economic abyss, there was little argument about the most appropriate policy stance. Central bankers felt compelled universally to use anything in their power to, firstly, stabilize the financial system and, then, put in place the foundations for a recovery.
Even the central bankers with the strongest aversion to inflation yielded to the evident public policy priorities to accept historically low interest rates.
Two and a half years along, the debate is becoming more divided.
On Thursday, European Central Bank president Jean-Claude Trichet signalled a change in the European stance as he introduced the words "strong vigilance" into the conversation about inflation. For Europeans, this is central bank code for a rate rise at the next policy meeting in April.
Europe's central bankers are required to put their fight against inflation ahead of any other goal. Those in favour of higher interest rates are arguing that the emergency has passed warranting a return to more normal levels to anchor inflation expectations.
The switch in sentiment comes as some countries in Europe, including Greece, Ireland and Portugal, remain mired in the second round effects of the 2008 financial crisis. They will face greater difficulties if tighter money is added to their already considerable economic woes.
Prospects for extricating themselves from their debt burden through higher growth will be lessened. The probability of debt default or restructuring will have been raised correspondingly.
Germany and France, on the other hand, appear in far better shape. Since they are the larger economies, their circumstances will be given greater weight in decision making. However, even their connections to the smaller economic laggards are unclear.
The European banks are going to be put through a second round of stress testing in March. One reason for this latest round of stress tests is that the first round tests were not sufficiently probing. All the Irish banks, for example, were deemed to have passed.
Even the larger and stronger economies may be home to smaller banks holding debt from the peripheral European economies making them vulnerable to a fresh crisis.
In the USA, meanwhile, there is mounting evidence of an ongoing economic recovery. While unemployment remains higher than the levels with which politicians and their constituents are comfortable, hours worked have been rising and employment growth has begun to push down on unemployment.
When Federal Reserve chairman Bernanke foreshadowed a second round of securities purchases in August 2010 to help boost economic activity, the employment situation appeared far bleaker than it is now. Perhaps, if he could have been confident about the trajectory, Bernanke might have baulked at further monetary easing.
Now, we have an equity market in the USA depending on a Federal Reserve commitment to raise asset values. Shortly, that prop is likely to be removed leaving the equity markets to stand on their own.
Corporate earnings seem set to reach record levels in 2011 so markets may be able to withstand the removal of Bernanke's support. However, economists' toolkits do not contain a device to help calibrate this transition with the desired or necessary precision. Getting it right will owe a great deal to chance.
Meanwhile, Australia's central bank has already raised interest rates on seven occasions since April 2009 as Australia's recovery ran ahead of the north Atlantic economies, partly due to its proximity to China and partly due to having had its own financial crisis within the living memory of many policymakers and corporate executives.
China itself has been on a tightening track with three rate rises in four months after nearly three years of no movement.
Overlaying these developments is the rising oil price. Central banks find it hard to decide whether higher oil prices should be regarded as a source of inflation to be stamped out or a drain on spending akin, in its effects, to a higher tax or an interest rate rise.
In reality, the answer depends on how easily costs become embedded in an economy. To the extent that higher oil prices lead to higher nominal wages which are then passed by employers to consumers via higher prices, a central bank probably needs to act. However, if neither workers nor corporates have enough market power to gain compensation, higher oil prices should encourage central banks to stand aside.
Central banks have been playing such an important role in the past two years that phasing out their influence is going to be especially difficult over the coming two or three years.
We are more than ever going to depend on the judgments of central bankers in 2011 as they graduate from the more straightforward decisions about economies in crisis to the more nuanced judgments about the likely speed of growth and the trade-off between the benefits of higher output and their aversion to having inflation accelerate.
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