US Fed and other central bankers could be promoting a severe misallocation of capital

As the news flow on further asset purchases and money printing by the US Fed leads to a further rally in risky assets this policy now runs the risk of promoting a significant misallocation of capital by its own citizens who, given their severe indebtedness can ill afford to make more losses after a lost decade in equities and a large amount of Housing Equity lying below cost. There is a huge talk growing about the fact that the saving rate has not reached 6% from around 2.5% and the fact that this is a positive development.

However the reality is that the savings rate has to not only sustain at such levels but has to further increase in the future as the value of a large amount of their current savings might not be making money and the pace of growth of working population in the country grows much slower than it has historically. The situation in Europe is worse with the working population actually declining, albeit at a slow pace over the next two decades. The savings rate actually needs to go upto atleast 10% for there to be any sort of comfort and for these economies to trend back to a 2-3% growth rate.

By making statements of keeping rates low for an extended period of time the Fed is making the general population complacent and making them believe that rates will be this way forever, as in general the lay person believes and extrapolates today into the future. There is also talk about trying to ignite inflation by using extremely loose monetary policy. However the reality is that given the fact that emerging economies are growing at a rapid pace, the extremely loose monetary policy will eventually increase the cost of living by increasing the prices of clothes, food, toys, autos etc. etc. and most other manufacturing products also. Given the high unemployment this will further constrict consumption and lead to lower economic growth. Also as I have argued earlier the impact of low rates which become something that is expected looses its effect and as it starts becoming taken for granted the impact reduces.

Given the fact that the financial system is still trying to rebuild their balance sheets and is extremely risk averse the money multiplier has come down sharply in most countries in Europe and the US. Also given the fact that a large amount of money flow is trend following, the flow is very high in Gold, Commodities & Emerging market assets. A large number of commodities are already trading at all time highs despite the fact that the economic recovery still remains extremely anemic.

It is important therefore to see where the incremental savings are going. Given the state of affairs, over a period of time the greater allocation will continue to be into riskier and riskier assets which could again lead to losses in case of times of risk aversion. It is clear that over the long run this is the right strategy, however only if it is coming out of real savings and not leveraged money because of extremely low borrowing costs. It is also a reality that a lot of money is trend following and really does not know why they are investing in a particular asset class.

In any case my point is that it is important to fear inflation rather than deflation as the fact is that the low inflation of the last two decades in most Western economies has largely been due to the low cost sourcing from China which now seems to have run its course. With wage inflation picking up in China, its own consumption growing and there being pressure to revalue the severely undervalued Yuan the imports from China will only become costlier. There is also no other country that can take the place of China as a manufacturing powerhouse, at least not at this point of time. The belief of central bankers that it’s been their actions that have kept inflation down is fallacious at best. If central banker’s action was so effective then we would not have seen two bubbles i.e. Internet and Housing bubble in a single decade.

Instead of trying to bounce back fast the Western policy makers should try to adjust to lower growth over the short run, rebuild the balance sheets of the governments, households and the financial institutions before aiming for higher growth. The asset purchases, at record levels by the US Fed and BOE are creating a false price for government bonds as the asset purchases by central bankers should ideally be added back to the Federal Debt to get the right picture of actual total indebtedness. The extremely low yields on risk free assets are leading investors towards higher yielding assets which obviously carry a higher risk. However given that we are just around 18 months off the last cycle low the defaults on new risky investments will playout only over a period of time. Lot of investors is also not looking at duration risk and I was amazed to read that Mexico raised 100 year money at around 6%.

In conclusion on this topic all I would like to say is that every news flow on additional QE by the US Fed is taken as a cue by the markets to take more risk which is highly risky in itself.

Markets

The extremely oversold USD looks to be starting a bounce back and the extremely over bought emerging markets look to be correcting now. The greater risk for the Indian markets stems from the fact that with record redemptions from mutual funds and tightening liquidity there does not seem to be much support for the markets in case of a short term reversal in FII flows. With borrowings from RBI from the REPO window increasing by the day and inflation not cooling off at the expected rate there is increased risk of a policy misstep from RBI of tightening further despite the impact of previous measures playing out fully. Makes sense to be cautious in the short run.

We will either find a way, or make one.” – Hannibal