The wait is finally over. The two-day deliberations of the Federal Open Market Committee (FOMC) ended in the early hours of Thursday (Asian time). The FOMC decisions disappointed the financial market that was expecting a magisterial wave of the magic wand by chairman Ben Bernanke. There was neither a wand to wave nor any magic to weave. That was the only good part of the meeting. There was no attempt at false bravado, to add to the already existing panoply of such measures—an open-ended promise to maintain interest rates at zero percent until mid-2013 and a bloated Federal Reserve balance sheet, etc. But hold your applause. The good sense will be ephemeral.
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The decisions taken by FOMC were to reinvest the proceeds of the agency- mortgage-backed securities in similar agency-mortgage-backed securities and to lengthen the maturity of its treasury bond portfolio by selling about $400 billion worth of short-term treasury securities and buying longer-dated ones.
In order to make the FOMC decisions appear “bolder”, the Fed listed decisions already taken—to roll over existing treasury securities and to keep the Federal funds rate unchanged until mid-2013, for good measure. Three members of FOMC dissented as in the last meeting. Two days of deliberations could not browbeat them into falling in line with majority opinion. That is another reason why FOMC could not announce anything dramatic. The open letter written by Republicans warning against monetary policy adventurism might have been a factor too.
US Fed Reserve Chairman BenBernanke(AP Photo)
Nonetheless, the clever packaging of existing measures into a long list of actions did not fool the market (that the market was ready to be fooled by additional quantitative easing measures is another matter). The market judged that the Fed had run out of ammunition and hence is fretting over deflation risks.
In the current “deflationary” phase, the dollar might be a touch firmer (the index of Asian currencies vs the US dollar is now down 3.6% from its peak) and gold might be in retreat. Long-term investors in the yellow metal should not panic, but use the opportunity to add more. They will be able to accumulate the precious metal at prices that will later appear as bargains.
In 2008, this Asian currency index dropped by about 13% from its then peak. We very much doubt if Asian currencies would repeat their 2008 swoon. If things get worse that investors flock to the US dollar (forgetting how risky the US itself is, in contrast to their delusions of safety in 2008) as they did in 2008, then the Fed would shed caution and unleash its inflation arsenal. That is why the sell-off in emerging market currencies this time is unlikely to be as steep as it was in 2008.
That is why I have deliberately put “deflationary” under quotes above because the current policy configuration is anything but deflationary. But the process of deleveraging and the market’s anxiety at not seeing more overtly inflationary policies will create a deflationary mindset which would prove beneficial to the dollar, briefly.
At the same time, we should not forget that the decision of the Fed not to go in for “bold” stimulus measures is a positive for emerging markets, even if temporary. Such a step—which will come later, as we argue above—would have been immediately problematic for emerging markets. That’s been postponed for now. Nonetheless, in the likely rush to the bogus safety of the US dollar, emerging stocks and currencies will be sold.
That is going to set up buying opportunities. Investors have to use fairly stringent valuation considerations in picking up emerging market assets and currencies, for another wave of sell-off would come after Western policymakers cast away all pretensions to prudence and generate higher inflation to reduce their debt burden.
Things have to get much worse for that last throw of dice and they will get worse. Economic data suggest that the US is on the edge of a recession. Inflation is not low but that won’t deter the FOMC. It will launch its inflation bazooka in December or early in the New Year. Witness, for example, how the Bank of England is preparing for another round of quantitative easing, despite no let-up in inflation.
But that last throw of dice won’t work either. That would be the climax of the events that began to unfold in 2007. Most of us would be collateral damage in the consequences that would be serious, profound and far-reaching. Conflicts—economic and/or military—cannot be ruled out.
This final chapter still awaits and that is why there should be no rush to buy emerging market assets right away. Investors should remain selective and slow to invest. Keeping a lot of powder dry for acquisition in 2013 or later is wiser. Right now, the goal should be to ensure that we remain standing until then.
V. Anantha Nageswaran is an independent macroeconomic and investment strategy consultant, based in Singapore.
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