Axel Merk November 5, 2009
The contrast between the Federal Reserve's (Fed) statement on Wednesday and the European Central Bank's (ECB) press conference today shows how the Fed imposes its credibility on the markets, whereas the ECB is earning it.
The Fed will look for "low rates of resource utilization, subdued inflation trends and stable inflation expectations" to keep interest rates low. Resource utilization is likely to remain low, so that's not a factor. Secondly, inflation trends will quite likely inch upwards as year-on-year comparisons will be tougher. That leaves the last point: inflation expectations. The Fed has to contain inflation expectations, but the Fed ultimately controls inflation expectations. The best way to control inflation expectations is through sound monetary policy. What the Fed is doing instead is to see whether it can get away with ultra-loose monetary policy without causing inflationary expectations to be dislodged. Differently said, the Fed will tighten only if the credibility in the Fed erodes as that would be the reason for inflationary expectations to rise. In the best of cases, this is a very risky strategy; it may be a precursor for a rather volatile, if not inflationary monetary environment.
The ECB has a different approach. To start out with, the ECB is upfront that inflation will return to positive territory as expected. This may partially be a reflection of managing inflationary expectations upward, but more to the point, it's a frank assessment of reality. While the Fed continues to expand its balance sheet, the ECB, when asked about the unlimited liquidity provisions, made it clear that it does not disagree with the market's assessment that these provisions will be phased out. That's an actual reduction in liquidity, whereas at the Fed, we talk about reducing the rate at which money will be printed.
With regard to exit strategy, the ECB has taken its mandate a step further and urges eurozone governments to lay out a "clear and credible exist strategy" to the fiscal spending initiatives. We have similar calls in the U.S., but using the press conference for such calls may be more effective than the Fed's approach to mention such wishes in speeches on occasion.
Finally, the ECB is using rather strong language to encourage banks to seek more capital. European banks may have more catching up to do, but the point here is again that the ECB addresses the challenges head on, whereas the Fed seems mostly interested in buying time.
It's not surprising to us that the euro has been outperforming the U.S. dollar. But then again, it seems to us that the Fed wants to have a weaker dollar - after all, why else would they buy government bonds and mortgage-backed securities, encouraging rational investors to look overseas for securities that are not intentionally overpriced.
Axel Merk Merk Investments President and Chief Investment Officer Axel Merk's new book SustainableWealth is now available.
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