Fed, ECB Can Promise, But Can’t Deliver
Like Pavlov’s dog, the market is conditioned to rise whenever investors see the possibility of central bank moves toward ease. This is true whether we are talking about the Fed or the ECB. The problem is that we have been gradually moving to a point where central banks can promise, but can no longer deliver.
Take, for instance, ECB President Draghi’s statement last week that the ECB will "do whatever it takes" to save the Euro and get the EU’s economy growing again. That bold statement was so clear and emphatic that most observers took it as a sign that that a really definitive announcement was coming this week. Instead we got the same old vague pronouncements that we have now been hearing from top European government and financial officials for the last two and a half years.
Following are some samples we picked up from some of the articles reporting on Draghi’s announcement today: May soon step in… consider other measures… only under strict conditions… provided Spain and Italy issue a request… will come up with a plan… could include… may undertake… will now examine… will decide… tied to strict conditions. For anybody who has been following this story since early 2010, it sounds like the same old vague "kick the can down the road" rhetoric we have been hearing all along.
The problem is that the EU is dealing with extremely high debt levels, declining economies, a sovereign debt crisis and an inflexible currency. The fact they must face is that the more successful nations (mostly Germany) just do not have enough funds to save the peripheral nations, which include Italy and Spain, the third and fourth largest countries in the EU. At best it seems that the EU is facing a severe recession for some time to come and, at worst, a run on the banks and financial collapse.
As for the U.S., the latest FOMC meeting indicates a paralysis of monetary policy in the face of extremely low growth and the dysfunction in Washington. Consumers are restrained by historically high debt levels of household debt, low savings rates, an uncertain jobs outlook, stagnant income and depressed housing prices. This leads to weak consumer spending and a desire to reduce debt.
The absence of enough consumer demand leaves businesses with excess capacity and no big need to expand. This means that businesses do not need a lot of credit and banks end up with abundant excess reserves that they can’t lend out, a condition commonly known as a low velocity of money. The upshot is that the usual transmission mechanism whereby easy monetary conditions lead to an expanding economy is not working. With fed funds rates close to zero and the Fed’s balance sheet already bloated, there is little the FOMC can do other than to engage in unconventional policies with unknown results and possible unintended consequences. That is why the Fed has recently been so reluctant to make a move despite economic circumstances that would ordinarily call for additional ease.
In our view the market is starting to realize that central banks can no longer bail out the economy, and that successive easing moves have had diminishing results. As the economy continues to slide, corporate earnings estimates, as well as results, will come down sharply as well. We note the S&P 500 closed today at about at same level as in late February.