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Sunday, 23 November 2014

The Fed, the ECB and the monetisation game

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The issue isn’t whether the Federal Reserve and European Central Bank are monetising debt now, it is instead whether their actions make them more likely to later.

James Saft, Reuters Columnist

For both institutions the game is to get the benefit out of buying up government debt, with all the very considerable benefits that brings in current circumstances, while retaining the market’s faith that when things get too wild they will unwind their purchases.

It isn’t that the Fed, or ECB, is monetising the debt, but rather that they are putting themselves in a situation where reasonable people might expect that they possibly would later. Not will, but might, but that is a big risk to introduce into events in and of itself.

Fed Chairman Ben Bernanke battled against this view in a speech this week in Indianapolis in which he attempted to dispel doubts about the U.S. central bank’s policies, including the belief that it is monetising debt – printing money for the government’s use - which will fan inflation.

“Monetising the debt means using money creation as a permanent source of financing for government spending,” Bernanke said.

“In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size.”

Fed and ECB bond buying may or may not be wise policy, but taking their defence of their policy at face value is definitely unwise for investors.

The key word there is temporary, and the key question is: who says?

The market’s faith that the Fed will control inflation is now based, at least in part, on its pledge to take the right actions to stem inflation if and when it becomes too high. So far, obviously, the Fed retains the confidence of savers and investors, and indeed it is fighting an uphill battle against money which is moving too slowly around the economy due to a general preference to pay down debt.

Consider the Fed’s position if it found itself with its current balance sheet but inflation expectations suddenly become unmoored, an unlikely but possible scenario. Would the Fed really under those circumstances join the market in selling Treasuries, sending interest rates very sharply higher?

Perhaps, but, especially given that it is already a very active and influential participant in the Treasury market, the temptation surely would be to continue to buy Treasuries or to accelerate purchases. There would be all sorts of compelling arguments in favour of continuing to buy debt, and even then under Bernanke’s definition it would not be monetisation if his intention was to later sell the debt. It might even be the right thing to do. Other market participants, with very different motivations from the Fed’s, understand this and if they think it likely they will act accordingly.

ECB out on a limb

This is not too far from the position the ECB is in with Spanish and other weak euro zone sovereign bond markets. ECB chief Mario Draghi, faced with disintegrating support from investors for doubtful euro debt, made the pledge in late July to do “whatever it takes to preserve the euro.” ECB support is conditional on countries making pledges of reform and change, and agreeing them as part of a bailout package. ECB purchases will also be sterilised, meaning that when the ECB buys a Spanish bond it will sell a Dutch one, or something else in its portfolio, keeping the amount of money stable.

Even so this implicit guarantee has every possibility of eventually turning into an explicit one, according to fund manager Jochen Felsenheimer at Assenagon Credit Management in Munich. Peripheral euro debt has rallied splendidly exactly because the expectation is that the ECB will step in if need be.

But what would the ECB do in an extreme situation? What happens if Greece, Spain, Italy, Portugal and France require aid? You may say that’s not likely, but it is impossible to say that if it does happen the ECB will definitely continue to sterilise its bond purchases.

“Seen from a game theory point of view, the ECB’s announcement only works if things never go that far,” Felsenheimer writes in a note to clients.

“The way in which this approach works can be likened to the policy of deterrence used in the Cold War. As long as nobody winces, nothing happens, If somebody winces, everyone loses.”

It is impossible for the ECB to have it both ways: you can’t pledge unlimited support without reckoning with that support’s implications and risks. Of course it is impossible, and would be foolish, for the Fed or the ECB to publicly discuss this in any way other than how they have, because doing so would only increase the risk of a bad outcome. Again, the disaster doesn’t have to come.

Fed and ECB bond buying may or may not be wise policy, but taking their defence of their policy at face value is definitely unwise for investors.

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