James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. – That much-anticipated global coordinated easing won’t be global, won’t be coordinated and won’t even be much of an easing.

In 2008 the world got global coordinated monetary easing, with contributions from central banks from Tokyo to Washington.

In 2009 virtually every member of the Group of 20 nations contributed to global coordinated fiscal easing, committing to a total of almost $700 billion in additional spending, or more than 1 percent of global GDP.

In 2011 we will get half measures, conflicting policy and self-preservation. This should be no surprise; not only has the crisis spread from being one about banks and houses to one about governments, it has also hardened the divisions between constituencies and interests.

Short of a not inconceivable breakup of the euro it’s hard to see this changing soon. The U.S. and Europe are riven by political and fundamental divisions, China is hardly poised to carry the water and the rest of the world is weak, small and looking to its own diverse interests. It is easier to see currency wars and protectionism rising than the linking of arms of 2008 and 2009.

The Federal Reserve on Wednesday said it would over the next year sell $400 billion of shorter term Treasuries already in its portfolio, using the proceeds to buy longer term Treasuries, a move intended to drive longer term interest rates lower.

This might buy the economy cheaper long-term interest rates of perhaps 20 basis points, but, considering that the Fed said there are now “significant downside risks to the economic outlook, including strains in global financial markets,” this is little more than a cold cup of coffee.

The Fed also threw in a splash of skim milk for that coffee, saying that it would now reinvest maturing mortgage securities it holds into new similar bonds.

Given that unemployment is 9.1 percent and the U.S. economy produced exactly no additional jobs in August, this hardly even qualifies as palliative care. That the Fed, which was split by a 7-3 vote on its decision, made the moves shortly after receiving a highly unusual letter from Congressional Republican leaders gives an indication of exactly how difficult its position has become.

House Speaker John Boehner, Senate Minority Leader Mitch McConnell, Senator John Kyl and Representative Eric Cantor asked Chairman Ben Bernanke to “resist further extraordinary intervention in the U.S. economy,” maintaining that it could worsen current problems or cause new ones.

President Obama’s $447 billion jobs plan will likely end up being less than half that size, if that, and could end up having far less impact on confidence and the economy than the discussions about cuts and the budget that will accompany it.

In the U.S., there is no consensus about what works and what should be done, only mutual cynicism about motives.

DISUNITED NATIONS

Expecting global coordination out of Europe seems a bit rich, given that it can barely coordinate policy internally. The parts of the euro zone that need stimulus most, Greece, Spain, Portugal, Ireland and Italy, are the ones the rest of the euro zone seem most bent on punishing with a self-defeating austerity.

After having led the European Central Bank into two disastrous rate hikes, Jean-Claude Trichet has toned down his rhetoric and the bank has cut its forecasts for growth and said the risks to inflation are now balanced, having previously been tilted higher. The ECB at least has room to cut, but continues to be deeply ambivalent about its real lever, its ability to buy up the bonds of countries like Spain and Italy.

While the Bank of Japan might be willing to add to a long-running program of buying assets, it is more likely to act to intervene to limit yen strength, effectively acting to send economic weakness back across the Pacific to the U.S.

Minutes from the Bank of England’s Monetary Policy Committee indicate that it may take another run at supporting demand through quantitative easing, a path stoutly advocated by member Adam Posen. Britain’s plans to cut its way to fiscal health are also under question, as weak growth caused it to record a modern all-time largest budget deficit in August. The IMF cut its forecast for British growth and said a policy reversal may be called for in the event of further weakness.

As for the Swiss, their signal contribution to coordinated policy has been to act unilaterally, pledging to cap the strength of the franc.

China’s economy will slow, but it remains constrained by inflation and high debt levels. To expect China to play along with a united U.S. and Europe is one thing, to expect it to lead and take extra risks onto itself is another.

While bond markets are preparing for disaster, the equity markets still appear to believe, at least a little, in the policy fairy. It may not take long to find out who is right.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own

HUNTSVILLE, Ala. – Tim Geithner went a very long way on Friday to accomplish very little, flying to Poland to pitch to the assembled euro zone finance ministers the same tactics that have worked so poorly in the U.S.

Faced with another debt problem, Geithner once again proposed more debt as the solution, suggesting that Europe should leverage its EFSF bailout fund so it can have enough firepower to buy up the debts of weak euro zone nations. This mislabels a debt problem as a price problem, and is an almost exact analogue to the U.S.’s own tactics in addressing its own financial system problem — creating leveraged funds to buy up toxic debt and thereby massage the balance sheets of banks.

This is the deflationary equivalent of reacting to runaway inflation by deciding to lop a zero off the end of prices; things will appear better but the underlying issue is not resolved. This is borne out in the U.S., where private fortunes continue to be made in banking, but where the system is unable to play its role in capital intermediation. Many lenders are still wary, rightly, of funding U.S. banks and are unconvinced that the toxic debt problem is gone for good.

The Europeans don’t appear to be buyers either. “We are not discussing the expansion or increase of the EFSF with a nonmember of the euro area,” said Jean-Claude Juncker, the chairman of the Eurogroup.

He also ruled out any further fiscal stimulus, something Washington has also called for. “Fiscal consolidation remains a top priority for the euro area,” he said.

Austria’s Finance Minister Maria Fekter went further, describing how Geithner urged the group to commit more money to the rescue, but flat out rejected the idea of funding the bailout with a financial transaction tax.

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone, that they tell us what we should do and when we make a suggestion … that they say ‘no’ straight away.”

Remember, Geithner isn’t proposing borrowing more money so that the deeply destructive cuts the euro zone is requiring in Greece and elsewhere can be eased. It is not money for teachers, it is money to support bond prices, which in effect is money to support the capital positions of the banks which would be left broken if the true market price prevailed.

SOVEREIGN CREDIT RISK ROULETTE

The problem with this is that ultimately supporting the banks may swamp the sovereign’s credit rating. A massive increase in the size of the EFSF would surely call into question France’s AAA rating. While Europe has a problem over who is going to pay, with Germans unwilling to underwrite what they see as Mediterranean profligacy, it also has a profound problem with which lenders to make whole.

A look at a study from the Bank for International Settlements into the interaction of sovereign credit risk and bank funding really shows the limits of Geithner’s leverage-happy approach.

Released as part of its quarterly review, the central bank’s central bank described sovereign credit risk as posing “a significant and urgent challenge to banks.”

Bank are massive holders of sovereign debt; indeed bank regulation hard-wires holdings into their business model. That leaves banks open to losses on sovereign loans held on their balance sheets, and in turn those loans are worth less as collateral for loans from the market or from central banks. On top of that, as the state is the ultimate insurer of its banking system, downgrades to the sovereign are effectively downgrades to its banks, raising their funding costs.

In other words, buying up sovereign debt at inflated prices without properly restructuring the debt will result in an ongoing European bank funding crisis, with ever more leverage needed until the day comes that the sovereign is no longer credit worthy. The bank funding and sovereign credit dynamic is one that must ultimately be broken by sovereigns repairing the stability of their finances.

Banks can mitigate these risks by holding fewer government bonds, and by funding themselves more conservatively, but those steps will tend to make them less willing and able to provide credit to the economies they are supposed to support. That is probably the way banks need to be run, but operating a bank conservatively in an economy in which debts have already been properly written down will result in good solid growth. Doing it in a make-believe economy with make-believe asset prices will result in years of stagnation.

That is what the U.S. is seeing. Europe should choose a different path.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE — Wednesday was a weird day, caught somewhere between being a victory for the paranoid and a genuine step forward for openness and transparency.

And no, I am not talking about the sad spectacle of President Obama trotting out his birth certificate to assuage his deluded doubters. I am instead speaking of the Federal Reserve, which for the first time in its long history has taken the step of actually taking questions from the press after announcing its monetary policy decision.

Unlike the birth nonsense, there are two not mutually exclusive ways you can interpret the Fed’s decision to put itself at the mercy of the hacks. First, it is a real step forward for transparency, a step along the way towards renouncing the cant of the era of Greenspan, who seemed to regard himself as part economist, part Delphic Oracle and part Wizard of Oz.  Second, it marks a waning of the power of the Fed, which has been diminished by its poor track record and by steps it took which opened it up to attack.

It is perhaps this second point which is more important; the Fed is under attack, under suspicion and trying very hard to husband its credibility. This is a tough combination of factors, and a state of play that could make it more difficult for the Fed to effectively fight inflation.

The most important weapon of any central bank is its credibility, which amounts to the faith that people have that it will follow its mandates. That’s not simply faith that a bank will do what it says, but belief that it can do what it says. For the Fed, which has a dual mandate to foster employment and keep a lid on inflation, this is sometimes nearly impossible. It may also not be something that is aided by transparency. Fiat money is a system of faith, and as many religions have found, faith and transparency don’t always mix.

“It used to be the mystique of central banking was all about not letting anybody know what you are doing,” Bernanke said during a notably uncomfortable performance in the press conference.

Quite right, it was not until the 1990s that the Fed actually began to announce its rate decisions. Before that they simply signaled them through market operations.

THE AGE OF DISBELIEF

The past decade has not been kind to the reputation of central banks, not least the Fed’s. Whereas once there was naive faith that economists, who played a cultural role not dissimilar to scientists during the early part of the Nuclear Age, knew what was best and would bring prosperity, now there is widespread doubt and distrust.

Wages have not grown, wealth has become more and more concentrated in a small sliver of the population and Americans have quite surprisingly not all grown rich by buying each other’s houses.

The central tenet of this belief system –  the idea that enlightened management had brought on a Great Moderation of low-volatility growth — is now discarded.  Many people distrust the Fed for having intervened too much, while others deride it for having done too little.

Will a press conference help to change this? Perhaps, but much of the problem is inherent in the situation and in the Fed’s dual mandate.

“So why not do more?” Bernanke said in response to a question about why he was not more aggressively fighting unemployment.

“The trade-offs are getting less attractive at this point. Inflation has gotten higher, inflation expectations are a bit higher, it is not clear we can get substantial improvements in payrolls without some additional inflation risks. In my view, if we’re going to have success in creating a long-run, sustainable recovery, we’re going to have to keep inflation under control.”

At one point Bernanke said that the longer unemployment persists the less it can be aided by monetary policy, saying instead it requires retraining, in a moment handing off some of his mandate to the Department of Education.

To be sure, to the extent that a press conference makes the views of the Fed more clearly known, it can help it in carrying out its intentions with a minimum of volatility and disorder. On this important measure, the conference was a reasonable success.

The larger issue is what happens when or if longer-term inflation expectations become unmoored and the Fed has to tighten meaningfully. When that day arrives I am not sure that a reasoned understanding of the competing pressures exerted on the Fed will actually increase the chances that they will be taken at their word.

I can’t help but think that would have been easier for former chairman Volcker in the bad old days of opacity than it will prove for Bernanke.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

If you think the recovery is firm and the risk of deflation has vanished, look at the three following numbers: $100, 3.44 and 20.

The first, everyone knows, is the price that New York crude oil touched briefly on Wednesday, driven 14 percent higher in just five trading sessions by conflict in Libya and concern over the reliability of supply elsewhere.

The second is the yield on 10-year U.S. Treasury notes, and if you are keeping score, they have dropped a rapid 28 basis points from early February, a drop that is telling you that bond investors do not believe the U.S. economy can easily withstand $100 oil.

The third, that 20 percent, is perhaps the most poignant, as it represents the current level, an all-time high, in the ratio of their disposable income that Americans are getting from government benefits.

That’s right: social security, food stamps, unemployment insurance and the like account for two out of every 10 dimes Americans have once they have paid their tax.

Those three numbers don’t say self-sustaining recovery, they say pressure on consumption, on wages and on asset prices.

They also will put pressure on the dollar and will loom over any attempts to normalize Federal Reserve monetary policy. How on earth do you raise rates or end quantitative easing if gasoline goes to $4 per gallon (readers from outside the U.S. may laugh bitterly here, but this is a heck of a shock to the pocketbook, even if it is a tiny fraction of European or Japanese prices).

“It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock,” David Rosenberg of Gluskin Sheff wrote in a note to clients.

“Because oil demand is relatively inelastic over the near term, this price shock is going to cut into real global economic growth and the question is by how much,” Rosenberg writes, before bringing up a real concern, a U.S. debt and political situation where further stimulus is highly unlikely.

“In the past, we would see governments trying to cushion the blow but with the public sector nearly everywhere grappling with sky-high fiscal deficits and debts and moving towards restraint, and with monetary policy already in uncharted accommodative waters, there is no leeway to provide any antidotes.”

MARGIN KILLERS
To be sure, oil prices may well fall back if supplies are not interrupted and if concerns, especially about the potential for serious unrest in larger oil-producing states such as Saudi Arabia, prove baseless. While oil shocks in the recent past have usually led to recessions, they tended to be sustained rises in prices.

Earnings at Wal-Mart <WMT.N>, the massive retailer which looms large at the bottom end of U.S. retailing, tells a story not of recovery but continued hard times, conditions which are tough to square with recent risk market ebullience. Revenues were weak and the company noted a growing trend of customers paying for goods in the U.S. with government assistance, a half a percentage point rise in just three months.

Wal-Mart shoppers will feel every penny increase in the price of gas keenly, and are going to be very unwilling, or unable, to accept further price rises driven by commodity inflation.

This could easily undermine company profits. While companies report rising prices on the things they buy, prices on the things they sell are not keeping pace, presumably because they find it difficult to raise prices without driving hard-hit customers away.

Significantly, regional grocery store chain Wegman’s announced on Wednesday a price freeze on 40 basic necessities for the year, saying they will absorb $350 to $400 in price increases themselves for a family of four over the next nine months. That is the kind of thing which hits margins, and not just at grocery stores.

Meanwhile, the political situation in the U.S. is not going to be sending any shoppers running for the stores. A bitter dispute in Wisconsin over public sector workers’ pay, benefits and collective bargaining rights will likely give many workers, and not just in the public sector, the idea that what they thought was theirs may be taken away. Disputes in Washington over budget cuts will only serve to reinforce the sense that the ratio of transfers to disposable income is headed down ultimately, recovery or not.

So, what might the Federal Reserve do? If the oil price hike is sustained but price rises do not feed through to wage pressure, they will keep rates at rock-bottom and leave their options open over quantitative easing.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?

In the end, as with all banks, even central banks, it boils down to trust.

Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:

“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”

So, because he intends to undo it later, he’s not doing it now.

This is both demonstrably false and deeply, at least for now, true.

False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.

Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.

You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.

Daniel Thornton, a vice president at the St Louis Fed,  suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.

NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.

Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.

That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.

While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.

“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.

In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.

Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.

For now, the controls are still in Bernanke’s hands, but keep watching the bond market.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

Call it what you like — war, tragedy or farce — but the disagreement over global currency exchange rates shows no sign of coming to a peaceful negotiated agreement.

Asked last week if loose Federal Reserve monetary policy was to blame for inflation in emerging markets, Ben Bernanke stoutly denied that it was anything to do with him, maintaining in central banker-speak that he’d been tucked up in bed at home at the time.

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries,” the Fed chief told reporters assembled at the National Press Club in Washington.

“It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Now on the face of it, that statement is a nonsense: regardless of emerging markets, like say, China, having tools at their disposal to put out the fire of domestic inflation, it is still possible, even likely, that Fed policy is partly responsible for widespread commodity price pressures.

Bernanke is right that rising living standards in emerging markets play an important role in price pressures and right too to point out that emerging markets have unused tools at their disposal.

“They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases,” Mr Bernanke said.

Bernanke argued that inflation in the U.S. did not yet appear to be a threat while high rates of unemployment were. Unsaid in this is that China’s policy of artificially keeping the yuan cheap has played a role in high rates of U.S. unemployment.

The U.S. stepped up its rhetoric against Chinese policy in a report from the Treasury Department last week, stopping short of labeling China a currency manipulator but calling the yuan “substantially undervalued” and complaining that “progress thus far is insufficient and that more rapid progress is needed.”

China for its part seems utterly unlikely to do very much to substantially address the issue of a weak yuan, based both on its track record and recent body language.

The truth is that this is a dangerous and destructive way to manage competing global interests, dangerous both in terms of the threats of inflation and hunger and destructive in the ways that Chinese policy has helped to distort the global economy over the past decade, albeit with a massive helping hand from overly loose U.S. policy.

A WIDENING CONFLICT
No one should expect the rest of the world to sit by as the dueling Chinese and American policies spray stray bullets into the crowd.

French Finance Minister Christine Lagarde on Sunday was forthright, blaming a, for her, highly inconvenient strength in the euro on the U.S and the Chinese.

“We must reform the international monetary system so that the euro is not caught in the middle, hit by the expense of trade-offs between two currencies that are deliberately weak,” Ms. Lagarde said in an interview on French television.

And while the word “China” did not pass his lips, U.S. Treasury Secretary Geithner’s meaning was clear on Monday on a visit to Brazil:

“Brazil is seeing a surge in capital inflows. This is happening for two reasons. First, investors around the world see Brazil growing at a faster pace and offering higher rates of return relative to other major economies. But these flows have been magnified by the policies of other emerging economies that are trying to sustain undervalued currencies, with tightly controlled exchange rate regimes.”

That is both true and not true; Chinese policy is terrible for Brazilian industry, threatening to turn the country into a larder for natural resources while suppressing other exports, but a lot of the money which is flooding the country and pressuring its currency upward is part of a huge carry trade that is directly attributable to U.S. monetary policy.

In this way perhaps the real risk of the currency skirmishes is that all countries are so focused on getting their share of global growth that they fail to take individual steps to control inflation, and thus allow it to grow rapidly in a way that proves difficult to control.

It does not have to work out that way; an inflation shock that does not become self-reinforcing will kill asset returns but whittle down debts in a very useful way.

The truth though is many countries are all trying to control the same knife at the same time and that is a tough way to whittle.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

Looking to hedge against a spike in inflation? Equities may not be much help.

Neither, for that matter, will you do all that well over the longer haul with bonds, cash or even commodities, at least on the historical evidence. In short, when it comes to investing, inflation is a real drag.

It’s impossible to know if, much less when, the current very stimulative monetary policy in the developed world will spur inflation, but increasingly indicators are raising concerns. Emerging market economies show signs of overheating, while prices of food and many other commodities are surging.

The traditional view has been that equities are an effective hedge against inflation, in least over the long term, because companies will, all things being equal, eventually pass on inflation to their clients as higher prices.

That’s the theory, but the practice may prove to be much different, according to a study by IMF economists Alexander Attie and Shaun Roache, who examined the performance of a range of traditional asset classes in the aftermath of inflation shocks.

“Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” according to Attie and Roache.

First, the authors looked at returns in the 12 months after inflation shocks in the period after the 1973 end of the Bretton Woods system of fixed currencies. The results were not surprising; bonds got killed, equities did badly, as did cash, while commodities were an effective hedge. Real estate investment trusts (REITs) did about as badly as equities, somewhat undermining the argument for real estate during inflationary periods.

All well and good, but really only of use for the small number of daredevils who are willing to make big asset allocation shifts over a short period of time.

For most savers, not to mention pension funds and endowments, the more useful question is how do you hedge against inflation for the longer term?

The results for equities were not encouraging.

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample,” according to the study.

“Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

Over the 18 months after the shock, real returns were negative, though less negative than bonds, which get hammered by inflation. Equities improve a bit over the next couple of years, but even when looked at in the long run of more than five years an inflation shock makes for losses in real terms.

IN THE LONG RUN WE’RE ALL …
As for the other asset prices, inflation proves very difficult to hedge against even over the longer term. Take commodities, the star performer in the first 18 months after inflation bites; spot prices decline in the medium term and when you get above five years after the inflationary event you are looking at actual losses in spot prices. This might be because inflation hits demand, but also might be because high prices spur greater investment in efficiency, which over the long term also moderates demand.

While bonds get killed in the first couple of years after an inflation shock, after about three years returns improve, presumably partly because investors demand higher yields to make up for nasty recent experiences.

Cash returns do a bit better, but even cash, which can go where it likes in search of better returns as inflation increases, fails to serve as a perfect hedge over the longer term.

So, how to hedge against inflation? Inflation-protected bonds such as TIPS would work, but to be a hedge you have to buy and hold to maturity, as outside forces can easily distort returns through the life of a given bond.

Given that inflation is a portfolio killer, why then are equity markets booming? Well, in emerging markets where inflation is kicking in first they are not. In developed markets, investors seem to be placing a touching amount of faith in central bankers. After all, if the Federal Reserve and ECB don’t pull the plug on stimulus in time, inflation can easily get out of control.

Or perhaps equity markets are betting the central banks will fail to stoke growth and be forced to blow a larger asset market bubble as a consequence.

Or maybe everybody thinks they will be the genius who gets out in time.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

If you have forgotten the credit crunch it appears you have company: U.S. banks are lending again.

Bank earnings reports and data from the Federal Reserve confirm that, at long last, banks are beginning to step up lending, a much-needed ingredient for a stronger and more sustainable recovery.

The good news is that lending is growing to commercial and industrial companies — exactly where you want to see growth if the U.S. is going to address its unsustainable dependence on domestic consumption. That’s good so far as it goes, but with a fragile euro and an undervalued yuan the upside is decidedly limited.

That’s because, in part, consumers are still quite restrained, or are being restrained, at least to judge by weak to middling lending levels to consumers and to support house purchases.

With 17 of the top 25 U.S. banks by assets having reported earnings, a lending turnaround is in evidence. Among the 10 largest regional banks, loan books expanded by 0.6 percent in the fourth quarter, according to FBR Capital markets, and nudged up slightly at the four mega-banks. This compares to a 2 percent shrinkage in the previous quarter and real carnage in the two years before that.

According to Federal Reserve data, commercial bank loans and leases shrank by 10.3 percent in 2009 and 6.3 percent last year, both a cause and a result of the recession and the sluggish and largely jobless growth which followed. Fed data from December shows business lending growing at a very good 7.4 percent annual clip, with continued weakness in home equity, commercial real estate and consumer lending.

The growth in commercial and industrial lending is significant, given the strength of the turnaround, but that sector is going to have to row very hard if consumers are unable or unwilling to spend freely.

A look at the Fed data for the first two weeks of January shows continued mild expansion of business lending combined with stability in real estate lending and a small fall in consumer lending.

NECESSARY NOT SUFFICIENT
It is for this reason, if none other, that the U.S.’s seeming inability to convince China to allow the yuan to strengthen poses such a threat to U.S. growth and to its medium-term prospects. Even if the Federal Reserve engineers asset price inflation, there is really little chance that domestic demand over the next few years can provide strong growth. The U.S. must export more, both for its own sake and for those of its creditors.

Consumer credit has actually been stronger than the headline figure if you adjust for loans the banks consider unlikely to be repaid, according to James Marple, senior economist at TD Economics.

“Correcting for charge-offs shows that household deleveraging did lead to a slowdown in credit issuance. On a year-over-year basis, revolving consumer credit was slightly negative in early 2010 — a new phenomenon for credit cards — while nonrevolving net credit issuance slowed, but did not actually contract,” Marple wrote in a note to clients.

“Importantly, over the last several months, there has been a considerable improvement in consumer credit growth. Even with the impact of charge-offs, total consumer credit rose in both October and November — the first two consecutive monthly gains since June and July of 2008.”

Remember, in a fiat money economy the creation of credit is the creation of money. The Federal Reserve couldn’t make banks lend by dropping interest rates, but it appears that its program of quantitative easing may have worked, at least on this measure.

The Fed’s recent Survey of Senior Credit Officers, which measures conditions in the business of lending to hedge funds and other securities firms, showed a similar thawing of conditions.

Banks are more willing to take on risk, according to the survey, and are making money available to financial markets more cheaply and on less stringent terms.

If QE has prompted the banking system to begin to create money again, will inflation be unleashed? My guess is that there is still too much slack in labor markets for that to happen, but there is every chance that we will see, or are already seeing, bubbles in asset markets.

While credit creation can be a self-reinforcing cycle, it is only a virtuous one if the credit is invested in areas that are productive.

The sweet spot for the U.S. would be consumer stability combined with a gently falling dollar so the country can, over years not months, export its way out of its woes.

The rest of the world is not, judging by recent events, going to want to cooperate.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email:jamessaft@jamessaft.com)

James Saft is a Reuters columnist. The opinions expressed are his own.

Apparently not satisfied with being unable to fulfill its dual target of price stability and maximum employment the Federal Reserve has set itself a third mandate: higher asset prices.

Speaking on CNBC at a Federal Deposit Insurance Corporation-sponsored forum on small business lending last week, Fed Chairman Ben Bernanke was asked how, in essence, his $600 billion quantitative easing programme could be called a success when interest rates and commodity prices had actually risen in response.

“We see the economy strengthening, its gotten better over the last three or four months, a 3-4 percent growth number for 2011 seems reasonable,” he said.

“Our policies have contributed to a stronger stock market, just as they did in March of 2009, when we did the last iteration (of quantitative easing). The S&P 500 is up about 20 percent plus and the Russell 2000 is up 30 pct plus.”

So, there you have it; the man who controls the printing presses congratulating himself for driving stock prices higher.

First off, this is a very low hurdle of success. It is a bit like playing battleships in the bathtub and calling yourself a great admiral for pulling the enemies’ ships under the water.

We know he can do it — as he says he has done it in the past. The question is: should he?

The theory is that higher asset prices, particularly rising asset prices, will help to restore confidence and will entice greater investment and consumption.

Consumers, feeling a bit richer, will spend a bit more, and businesses will respond by committing to investment in new capacity to meet new demand.

Money parked on the sidelines will go from feeling smart to feeling stupid and will move into riskier assets like stocks or high yield bonds.

On this analysis, Bernanke and his supporters on the Federal Reserve are exactly right, some of the money that is summoned from the ether by rising stock prices will be spent and that once notional cash will have a real impact.

But really, how well did this work out the last couple of times it was tried, first in the 1990s and then again in the last decade? Not well.

Many Americans committed to spending programs that their earning power really wouldn’t support and huge and insupportable debts were created in the process. The dotcom and housing bubbles were produced and duly burst, and each successive bubble dealt deeper damage to the financial system and global economy.

KEEPING IT SIMPLE

While we have known for months that the Fed was targeting asset prices with QE, it really is shocking to hear it enunciated so clearly.

As money manager John Mauldin mused in a letter to clients, would the Fed be setting targets for shares? Were there other assets it would like to target?

The Federal Reserve is deeply compromised by doing this; it is two thirds of the way down a slippery slope and the mud is starting to fall from above.

The policy may not work and may have considerable unintended consequences, as hinted at by Philadelphia Fed President Charles Plosser in a speech on Monday.

“The notion persists that activist monetary policy can help stabilize the macroeconomy against a wide array of shocks, such as a sharp rise in the price of oil or a sharp drop in the price of housing. In my view, monetary policy’s ability to neutralize the real economic consequences of such shocks is actually quite limited …

Attempts to stabilize the economy will, more likely than not, end up providing stimulus when none is needed, or vice versa. It also risks distorting price signals and thus resource allocations, adding to instability. So asking monetary policy to do what it cannot do with aggressive attempts at stabilization can actually increase economic instability rather than reduce it,” Plosser said.

Perhaps even more disturbing is the idea that the Fed’s bathtub play with stocks and shares opens it up to outside pressure which could fundamentally undermine both its reputation and independence.

As was the case with its decision to direct capital to specific sectors of the economy, bubbling asset prices will be viewed by people like new Congressional Monetary Policy subcommittee Chair Ron Paul as an infringement of Congress’ traditional control of the purse strings.

When it comes to purchasing securities the line between fiscal and monetary policy becomes all but meaningless, and so the Fed’s action is a counterweight to inaction by Congress and the Executive branch.

More stimulus may well be what the economy needs, but if true it needs it from the fiscal side rather than by encouraging more share holders to spend more money they haven’t really got.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)