Don't Fight the Central Bank Rally

After the financial and economic disruptions and political shenanigans of the past several years, I suppose nothing should surprise us. I was nevertheless thrown a bit when headlines began appearing suggesting that the U.S. government could circumvent the statutory limit on Treasury debt by minting a $1 trillion coin and depositing it with the Federal Reserve. The ploy was supposed to work because, while the Federal Reserve has sole authority to print greenbacks, the Treasury Department has the power to mint coins, and the way the government pays its bills is to deposit money (normally tax receipts and bond proceeds) with the Federal Reserve and then write checks on those deposits. So why not mint a coin of whatever value, deposit it with the Fed, and then start writing checks--all without issuing another dollar's worth of treasury bonds?

The trillion-dollar coin trick, of course, popped up as an option to circumvent the House Republican leadership's threat to tie approval of additional federal debt issuance to a dollar-for-dollar reduction in future spending. Even before the GOP determined to move the budget debate back to the budget itself (where it belongs), Treasury firmly denied that it had any intention whatsoever of playing the coin trick, but the fact that anyone could think it a good idea serves as a caution to investors about the direction of fiscal and monetary policy in several important parts of the world.

What is that direction? The term that captures it best is "reflation," the use of monetary and fiscal policy initiatives to accelerate economic growth, consumer prices, and asset values. The objective is to create a sufficient momentum in the private economy to sustain a self-reinforcing cycle of growth in employment, production, and investment. The efficacy of such policy measures, their costs versus their benefits, dominated much of the economic debate of the past three quarters of a century. I'm not going to presume to judge that debate here, but I do want to recognize that reflation appears to be getting a renewed push in several large economies with implications for the assumptions investors may have made about what they expect from their portfolios.

For evidence of reflationary fiscal policy, start with the much unloved compromise that resulted from the so-called "fiscal cliff" debate at the end of 2012. Commentators have correctly noted that the deal's tax increases, falling mainly on the income of top earners and much less heavily on the paychecks of everyone who's paying into the Social Security System, amount to a drag on growth in 2013 of about 1.5 percent of gross domestic product (GDP). What those comments omit, however, is recognition that the fiscal cliff deal's combination of "permanent" tax rates and on-going spending produces a 2013 federal deficit of about 7 percent of GDP, a level that expansionary--that is reflationary--from almost any perspective.

To that extension of expansionary fiscal policy, we can add the Federal Reserve's on-going monetary policies. Unless economic results take a surprising direction, we can expect the Fed to continue to use its money-creation powers to buy some $85 billion in government issued or guaranteed debt each month throughout the year. Over 12 months, that program could exceed 10 percent of this year's U.S. GDP: Reflation.

The U.S. isn't alone in setting a reflationary course. Countries around the world have addressed slow economic growth by adding fiscal and monetary stimulus. The most notable development in this arena is the policy agenda in the world's third-largest economy, Japan, where the recently elected government reportedly plans some $136 billion in supplemental government spending and the Bank of Japan, under pressure from the new prime minister, seems likely to double its 1-percent inflation target and expand its own asset purchase program. Whether these familiar measures do much to generate real economic activity remains to be seen, but the headlines have already had their effect in depressing the exchange value of the Japanese yen, a reflationary change from the perspective of domestic consumers and businesses.

Although Europe with its adherence to Austrian-school economics appears to stand out as an exception to this reflationary pattern, keep in mind European Central Bank (ECB) President Mario Monti's promise to "do whatever it takes" to defend the euro. World bond markets have taken this statement to mean that the ECB will expand its balance sheet to buy sovereign bonds from peripheral countries, like Spain and Italy, should they lose access to public markets. Further reflation could be waiting in the wings.

Don't get me wrong. These expansionary fiscal and monetary policy moves may be exactly what the world's slow-growing economies need. In fact, global stock markets have so far this year applauded reflation. And we didn't see the fiscal lunacy of a $1 trillion attack on the soundness of the U.S. currency. My concern is that investors, in an understandable effort to keep their assets safe, have underestimated the potential for reflation to deflate their future standard of living. As powerful central banks have or stand ready to take further reflationary actions, many investors have clung to cash or supposedly "safe" low-interest-rate bonds out of fear that more obviously risky markets, like stocks, might move against them. While such concerns are reasonable and good reasons to keep some emergency cash stashed under the mattress, when governments around the world tell me they want prices to go up, I want to be sure that some prudent portion of my portfolio is positioned for the potential (though never the certainty, alas) that they can keep pace.

Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.



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