A Delicate Balance

It might remind some of a choreographed duel in a stage play. The Federal Reserve (Fed) and the European Central Bank (ECB) are carefully playing off each other’s moves. The result is that each has leveraged the other’s policies to exert the greatest impact on global audiences, that is markets, particularly currency markets. It probably was not planned this way, but so far it is working out to enhance global prospects. Such matters, however, whether on stage or in policy circles, carry significant risks.

Here is the state of play at the moment. The ECB faces a desperate situation. Despite a smattering of favorable statistics, it is beset by a triple threat: the potential for deflation, the prospect of a third recessionary dip, and the likelihood of financial turmoil, especially should negotiations with Greece fail to reach an acceptable accommodation. In response, it has pushed interest rates down, in some cases into negative territory, and initiated a truly massive bond-buying program, what central bankers call quantitative easing. On its own, such a policy agenda would tend to depress the value of the euro, especially next to the dollar. But because at the same time the Fed has stopped its program of quantitative easing, slowing the flow of dollar liquidity into markets, and planned gradual interest rate hikes, the currency effects have received a major fillip.

For the time being, this choreography, accidental or otherwise, seems to be working well. The euro has fallen some 25 percent against the dollar during he past 12 months, brightening prospects for euro-zone-exports without, if recent evidence is any indication, unduly impairing U.S. growth prospects. Given the parlous state of the euro-zone these days, borrowing some growth momentum from the United States in this way would seem to enhance the longer-term interests of both regions. After all, the U.S. economy is not so strong that it could withstand the financial-economic crisis that could otherwise engulf the euro-zone and spread quickly across the Atlantic. Meanwhile, the emerging economies, which could suffer from the slowdown in the flow of dollar liquidity, should benefit from a substitute in the expanded flood of euro liquidity, and any prosperity there can only enhance global growth prospects

But investors trying to negotiate the situation must also realize that this is a very delicate balance indeed. Should U.S. policy makers try to resist the dollar’s rise, say by postponing rate increases or returning to quantitative easing, the chance of a euro-zone collapse would multiply and so also would the risks of financial strains and an economic setback in this country. On the other side, should the ECB push current trends to extremes – if the dollar, for instance, were to quickly rise another 20-30 percent – then the U.S. recovery would come under threat and with it so would the well spring of growth in today’s global system. With central bankers on both sides of the ocean aware of the balance, the odds favor continued favorable tradeoffs, but the risk of a mishap is clearly present. The greatest threat comes from politics.

On the American side there is this recent push in Congress to exert more oversight over the Fed. To some extent, the effort is entirely reasonable. The Fed, after all, is the product of congressional legislation. Congress has a right, nay an obligation, to audit it, review its success, and ensure that the bank’s leadership is executing its powers according to law. But if Congress were to extend its influence to direct policy, the chance of countermeasures against the ECB would rise and so too would risks to the present, careful monetary policy balance.

Matters on the European side are more complex. The euro’s decline so far has benefitted the stronger economies in the union, Germany most notably. The weaker, less cost-effective economies in Europe’s so called periphery would need a lot more euro depreciation to make themselves globally competitive. Should their needs create an ascendant political pressure on the ECB, then the risk of a still more aggressive policy aimed at radical euro depreciation would rise and with it the chance that excessive dollar appreciation would stall the U.S. economy and bring down the global economy with it.

For the time being, the central banks have managed to choreograph this ballet successfully. It remains on pointe and likely will continue that way as long as they retain control, at least it is more likely to do so than otherwise. Generally, then, circumstances point to a benign investment environment. But significant risks exist, and investors cannot ignore them.

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