Home »Business & Finance » Managed Funds » Fed quandary shows finance lost in economic space

FederalweLONDON: US Federal Reserve is in a quandary. After four years of what used to be considered extraordinary monetary policy near-zero interest rates plus extensive money-printing members of the central bank's ruling committee are expressing concern about "the potential costs" of more of the same, according to the minutes of the December meeting.


They're probably worrying about creeping inflation. But the greater danger lies in mispriced financial markets.


The Fed's intentions, and those of governments running huge deficits, are worthy. State spending is supposed to put money into a cash starved economy. The central bank's reduction of the returns on savings is supposed to encourage consumer spending.


It's not clear how much these policies have helped. The recovery from the 2008 financial crisis and subsequent recession remains slow, but might have been slower with less aggressive policies. One effect is certain, though. Prices of financial assets no longer accurately reflect economic reality.


Such dislocations matter. These prices are supposed to provide signals to economic actors to help them decide how much to save, borrow, spend and invest. The signals are on the blink.


Misinformation all around Start with interest rates in the private sector. They now reflect the will of governments, not the wisdom of markets, so savings rates bear no relation to the theoretical "equilibrium" level, which would balance the desires of savers with the potential returns from investments.


Instead, savers look forward to an indefinite period of negative real returns.


Distorted borrowing costs also leave companies with no idea of their ultimate cost of capital.


Equity and commodity markets are also giving out random misinformation. In theory, these prices are the best available indicators of prospects.


The prevalence of speculators has always made that theory look optimistic. In the current distorted environment, it looks almost insane.


Both corporate profit and asset prices are driven far more by monetary conditions than long-term growth prospects or competitive positions.


Perhaps the biggest distortions are in government debt. Extremely low yields reflect a rigged market.


Vast quantities of new borrowing are transmogrified into even vaster quantities of newly printed money.


The conjured funds are spent in large part on government debt pushing prices up, and yields down.


Bad prices mean bad, or no, decisions. As the months of abnormality drag on, the bad effects become more serious.


Banks and speculators start to believe that ultra-cheap and abundant funds will be around long enough to support profitable but ultimately unsustainable leveraged structures.


Companies and households become more cautious, rightly worrying about the traumas that will come whenever the financial world moves from strange to normal.


They may well think that today's low government yields are an invitation to future disaster.


The good news is that many sensible executives have already stopped taking financial indicators seriously. For example, oil producers and miners would be investing wildly if they interpreted their very high returns as indicative of the scale of unmet demand and the future level of prices.


But bosses and boards realise that prices and the profit they generate are misleading. Instead, they rely on supply and demand trends and have invested relatively cautiously.


Managed distortion is no longer justified Paul Krugman and other economists who endorse extraordinary policies argue that governments are not like households, which should balance revenue and expenses, and that central banks are not like regular banks, which should not lend more than they can borrow.


The thinking is that the authorities can and should use their power to distort financial markets to remove another more sinister distortion unnecessarily low demand in the real economy.


That case is persuasive in extraordinary time war financial crisis or economic disaster.


But times are now looking fairly ordinary, nothing worse than a slow adjustment to the end of a credit bubble. In this environment, continued distortions of the signals from the financial system might push the economy in the wrong direction.


They reduce confidence now and could create worse financial problems later.


The underlying problem is simple. Honest prices, like truth in labelling or quality control, are a hallmark of a sound industrial economy, because they support efficiency and trust.


Dishonest prices whether for bread or bonds, soap or shares are distasteful and dangerous.


Center>Copyright Reuters, 2013

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