There's more than one way to run a central bank, which inevitably leads to the possibilities of success or failure. The trick is figuring out if one or the other's likely, and if the expectation is already priced into bonds and other assets.
With that setup, we turn to the Thursday's announcement by the European Central Bank to hold rates steady and keep its benchmark borrowing rate at 4.0%. In the related press conference, ECB president Jean-Claude Trichet made it clear that rising inflation played a role in the decision.
For the casual observer, taking a tough stand on inflation may seem like an easy choice for a central bank, but investors shouldn't assume that the ECB's hawkish disposition is the default position.
Witness the Federal Reserve of late, which finds it far easier to cut than stand firm. In fact, on Thursday, Fed chief Bernanke signaled that even more rate cuts are coming. In a speech in Washington he said:
In light of changes in the outlook for and the risks to growth, additional policy easing may well be necessary. We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.
The fear is that recession, if not already here will soon arrive in the U.S. As an antidote, the central bank will slash the price of money in the coming weeks and months. Indeed, the February '08 Fed fund futures contract is priced in expectation of a 50-basis-point cut when the FOMC meets at the end of this month.
No one should be surprised that the Fed will continue cutting rates if the economy continues to falter. But investors should recognize that the medicine may not work well this time, if at all. A generation of minimizing if not sidestepping recessions by deft monetary policy has kept the economy humming with only brief and mild contractionary interruptions. This time, the Fed will try to keep the game going once more.
The trouble is that the economy's not in trouble because interest rates have been too high. Quite the opposite has been true: the price of money's been too cheap for too long, and the excesses that flowed from that state of monetary affairs are correcting. The idea that the Fed can keep consumers spending at a sufficient rate to keep GDP from sinking seems a bit far-fetched. Then again, don't underestimate the power of the central bank. We may yet see a fresh season of zero-percent-financing deals and commentary that fuses helicopters with monetary policy.
It's any one's guess is Joe Sixpack can be convinced to keep spending as if the economy's booming. There is no doubt that the Fed will try. But it's tougher this time and Congress may also have to lend a fiscal hand. A fresh round of tax cuts, any one?
Even if all this works to keep the U.S. out of a deep recession, the cost is likely to be steep in terms of future inflation. Somewhere, somehow, some day, the bill must be paid. The warning signs are certainly clear: a falling dollar; rising prices for gold, oil and other commodities; and consumer prices that are moving higher as well, to name a few. Of course, this is an election year and short-term gain will be sacrificed on the altar of long-term pain. It's an ancient tradition, and it's not about to stop here.