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Full Twist, With 2.0 Degree of Difficulty

The Fed’s new twist strategy applies a new (or very old) tool to lower long-term interest rates to promote easier financial market conditions and economic growth. The equity market sold off sharply nonetheless. Investors seemed to be reacting to the Fed’s economic bearish assessment, which suggested that the risks of recession had increased. However, the Fed was merely acknowledging what most analysts had been saying over the past few months.   The key message is that the Fed remains committed to doing whatever it can to promote a healthier pace of growth and that its actions speak louder than words.
Expectations for new aggressive policies to address the financial turmoil in Europe have been disappointed for months now, but the discussions this weekend at the IMF meetings suggest that governments are finally getting the message that they need to act to shore up the sovereigns and banks they intend to support. Everyone is telling the Europeans they must act much sooner than they have. Investors need clarity. If the European Financial Stability Facility (EFSF) is increased and leveraged, as seems more likely now from the direction of current discussions, the EFSF would be able to provide a dramatically higher level of support for the debt of those countries that are making progress in reducing their budget deficits. There is also talk of setting up the European Stability Mechanism much sooner than its planned July 2013 launch date. But these conversations must quickly lead to implementation. Trichet’s retirement from the ECB is also timely. Expect his successor, Mario Draghi, to push for a decrease in policy rates by the ECB quite soon.
What do both the Fed and European actions have in common? Both reflect additional steps each must take to improve an unsatisfactory economic condition. In the U.S., the Fed remains highly committed to strengthening the expansion. Growth is too slow to create sufficient jobs to reduce unemployment materially. As long as this remains the case, more policy actions can be expected from the Fed. And they will keep at it until conditions improve. Some critics suggest that policy action won’t help. Even if this were true, which I strongly doubt, it is a very safe bet the Fed will continue in its efforts to improve economic conditions.
In Europe, policy actions have been slow in coming. Initially, pressure was exerted on nations to reduce their budget deficit. Then, when markets doubted the success of this strategy, funds were organized to buy debt of the indebted countries to keep their interest rates down and to buy them time for additional budget restraint, while enhancing liquidity facilities for the banks that own the sovereign debt. But more is necessary, including recapitalizing the banks, so they can withstand a sovereign default. The situation should be greatly improved if such facilities are put into place. Finally, this outcome seems to be coming into view. It is sorely needed and it has been painful waiting for the Europeans to recognize that the situation is sufficiently dire that they must overcome the political hurdles. But we seem to be approaching this point now.