The Federal Reserve’s latest policy initiative has been greeted with a universal chorus of disapproval. Observers are concerned that quantitative easing will increase US inflation and devalue the dollar. Inasmuch as expectations affect outcomes, these criticisms suggest that the policy is already working.
Currency devaluation and faster nominal economic growth are the only plausible ways in which the US can address the twin problems of structurally high unemployment and excessive household and government debt.
Job creation remains the key to economic recovery. Over the first eight years of this decade, the US saw production employment decline by approximately 2.4m. Most of these workers appeared to be absorbed by the construction sector, where employment rose 2.6m over the same period. In simple terms, globalisation displaced a significant fraction of the workforce, as manual jobs relocated to lower wage foreign economies. This trend was temporarily masked by a construction boom, fuelled by the inflation of a credit bubble between 2004 and 2007.
Once the bubble burst, all the construction jobs created during the boom vanished and the past increase in structural unemployment became visible. There are currently some 4m unemployed manual workers in the US, and there are few obvious potential sources of demand for their skills. The US is therefore afflicted by a structural increase in the long-term unemployed, a problem with which Europe has long been familiar.
Yet the US is uniquely ill equipped to deal with this phenomenon. In Europe, displaced workers are supported by a reliable long-term social security system, providing space for workers with redundant skills to retrain and eventually rejoin the workforce. The success of this system is visible in the halving of the eurozone’s ranks of long-term unemployed from 2.25m in 1998 to 1.2m in 2008.
Unfortunately, the European solution is not available in the US, where unemployment benefits expire after just 26 weeks, although they have been temporarily rolled over for longer periods.
All of which leaves the Fed in the position of a last resort social security system, a point that explains its traditional policy hyperactivity. At the current juncture, the Fed needs to generate a very large number of job openings for manual workers. Although some of these jobs are now being created as growth broadens, the bulk of potential positions has been lost to lower cost foreign economies.
In the absence of long-term government social support and retraining, the only available strategy is therefore to try and bring some of these lost jobs back home. QE is an efficient tool to procure this outcome, albeit more of a bludgeon than a lancet.
Those developing economies that chose to shadow the dollar find themselves importing a wildly inflationary monetary policy. Whether the net result is rapid wage inflation or currency revaluation among the developing economies, the eventual outcome is that the US gains competitiveness and those crucial lower-skilled jobs come back home.
Just as the US exports inflationary monetary policy, so the developing world will export inflation back to the US as commodity prices rise and as the competitive restraints on developed economy wage rates weaken. But higher US inflation is not unwelcome. Any lingering deflationary risks are being vaporised by rapidly rising inflation expectations. Meanwhile, inflation, which we might more politely term faster nominal gross domestic product growth, will erode the real burden of excessive debt currently weighing down the household and government sectors.
Overall, the Fed’s chosen strategy is logical and probably unavoidable. For investors, there are several implications. Firstly, the world is likely to experience a period of accelerated nominal GDP growth, a development that has a material bearing on a host of economic fundamentals ranging from corporate profits to budget deficits. Secondly, currency trends are likely to prove considerably more extensive than envisaged. Thirdly and finally, higher inflation creates winners and losers among asset classes, sectors and companies.
In practical terms, this suggests staying very long equities, where consensus earnings forecasts underestimate nominal GDP growth in 2011 and 2012 and where valuations should be inflated by a prolonged period of zero or negative real interest rates. The outlook also suggests staying very short the dollar. To judge from the historic sensitivity of the US trade balance to the currency, a further depreciation of 15-20 per cent is needed to generate a movement in net trade that might be enough to lower long-term unemployment.
On individual companies, investors need to consider who has pricing power and who does not. Lastly, given medium-term prospects for inflation, it is hard to find anything positive to say about bonds.
Carping at the Fed may be fun, but investors’ attention might be focused more usefully on these points.
Tim Bond is investment strategist at Odey Asset Management
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