Fed’s desperation is watershed moment

Was this week the watershed? Many different developments round the world suggested that it was – but left wholly unclear in which direction we are heading.

In politics, the US electorate delivered a crashing rebuke to President Obama, only two years after he was elected on a wave of euphoria. The Democrats’ defeat showed that Americans still believe themselves to be trapped in a severe recession.

The Federal Reserve also reached a watershed moment. Ben Bernanke, the chairman of the US central bank, had already broken many shibboleths by suggesting that he wanted inflation to be higher. That is consistent with an economy in extreme duress.

On Wednesday, the Fed went ahead and launched a second programme of quantitative easing, or QE2, to use its ubiquitous nickname. It will spend another $600bn on buying Treasury bonds. By increasing the demand for the bonds, this should push up their price, and hence push down their yield, or effective interest rate. As they are buying the bonds with money that they have created, this should by orthodox monetary theory be directly inflationary. Such an action is only imaginable, then, in desperate circumstances.

So far, so sombre. Now the waters grow murkier. Economic data this week was almost uniformly positive. In China, the UK, the eurozone and the US, ISM surveys of purchasing managers, great leading indicators of economic growth, moved sharply and surprisingly upwards. They are set so that a level of 50 is the dividing line between recession and expansion. In the summer, it looked as though they could drop below 50 – now all of them are at least 55. Yesterday’s payroll data, showing 150,000 extra jobs in the US, strongly suggested that the economy was improving.

Outside the US, the Reserve Bank of Australia actually raised rates this week. (China is also doing the same.) The central banks of weaker economies, including the Bank of England, decided against QE.

Finally, markets in their own reality had their own watershed. The US stock market has broken through to a new high for the year, and a new post-crisis high. The same is true of the oil price, also now at a high since the Lehman Brothers bankruptcy 26 months ago. For markets, the past week’s news was all good.

This is because the market cares about cheap money to the exclusion of almost all else. As the chart shows, stocks in the past two years have been explicable almost wholly in terms of the price of money. Using the three-month Libor rate at which banks lend to each other as a proxy, we see that stocks galloped once rates fell sharply in early 2009, and had no second thoughts until the spring of this year, when money markets thought the Fed might start tightening again. Now, with tightening off the table, markets can rush onwards.

That explains the market. But why is the Fed going to such an extreme when the economy might be improving? The answer is the US housing market. Mortgage rates have fallen further than treasury yields, making houses more affordable than ever, but house sales remain depressed. If housing stays moribund, this will have two serious negative effects.

First, there will be more defaults, and thus more damage to banks’ balance sheets. Note that the Fed is buying shorter-dated bonds, which helps banks, whose business is to borrow in the short term and lend in the long term.

Second, people will continue not to be – or feel – rich, and hence will not spend much. Since the early 1980s, strong asset prices have created wealth for Americans, which they have spent. If housing stays in the doldrums, these wealth effects will stay negative. This could shackle the economy, unless consumers can be shocked into spending.

What should investors make of this? All else being equal, cheap rates of borrowing are good for share prices. The market rally is not irrational. But two recent episodes illustrate the dangers. In 1998, after the Fed cut to unfreeze credit markets after the implosion of the Long-Term Capital Management hedge fund, and again in 2007 after it cut to get the markets through the first great tremor of the credit crisis, there were market recoveries. But money is fungible. The money went primarily not to the places that needed help, but where it was expected to earn the greatest return – internet stocks in 1998 and emerging markets in 2007. Good investments turned into bubbles that burst with devastating consequences.

This time round, emerging market debt already looks absurdly expensive. Food prices are rising sharply. The Fed has decided it can bear the risk of asset price bubbles, and so the market will test its resolve. For the Fed, this is truly a watershed. For investors, there is money in bubbles, so it is best to go with the herd and buy anything that would benefit – gold, oil and emerging markets could all rise much more before the bubbles burst – and make sure to get out in time.

This is an extremely dangerous way to try to make money. But then the Fed’s way of stimulating the economy, while possibly necessary, is also extremely dangerous.

john.authers@ft.com