S&P v Nikkei.pngIf you only read one newspaper article this year on the economic outlook, then the blog would recommend Martin Wolf’s recent analysis ‘Why America is going to win the global currency battle’.

Wolf is a former EPCA speaker, and he sets out very convincingly the rationale for the US Federal Reserve’s planned move to restart printing money again (the QE2 Lifeboat policy). As he says:

To put it crudely, the US wants to inflate the rest of the world“.

Wolf argues that the Fed’s QE2 policy will encourage asset price inflation in financial markets (stocks, commodities etc). The belief is this will spur US consumer spending and promote growth in the real economy. Higher US inflation will also devalue the US$, thus reducing the ‘real’ value of the US’s enormous debt.

Equally, of course, the article highlights Fed’s real fear that the USA may be following Japan’s deflationary path since its financial and real estate bubbles burst 20 years ago. The chart above shows this danger very clearly:

• The bottom axis is the percent change in the Nikkei 225 Index (purple line) from September 1985
• The top axis is the percent change in the S&P 500 Index (red line) from September 1995
• The S&P line is lagged by 8 months, so that it peaks in 2000 in line with the Nikkei’s all-time peak in 1990.

It shows how the Fed began inflating like mad in 2003 – focusing on the housing market – as the S&P followed the Nikkei’s downward path after the dot-com bust. The resulting Crisis, however, then brought the two lines perilously close again in 2009. Thus the Fed is clearly very worried that this summer’s ‘soft-patch’ may signal that the USA is reconnecting with Japan’s fate.

The blog, does, however, disagree with Wolf’s overall conclusion, that the Fed will inevitably win this battle. Wolf believes that its policy will force China and other emerging economies to allow their currencies to rise sharply, or risk higher inflation and over-heating in their domestic economies. This will then allow the US to increase its exports, and also help to rebalance the US economy.

But he overlooks the impact that the lower US$ and higher commodity prices will have on US domestic demand. Higher oil and food prices, brought on by the ‘QE2 Lifeboat party’, are just as likely to cause further declines in US consumer confidence, and cut into the discretionary expenditure that drives growth in the real economy.

The problem, of course, is that the Fed is certainly powerful enough to engineer a short-term boom in asset values. This is what we have been seeing with the 15% rise in the S&P since August, when the Fed began briefing on its proposed policy. But can it really ‘win’, as Wolf believes?

In the blog’s view, this just adds to the general uncertainty over likely future demand levels, that was so evident earlier this month at EPCA. And it is therefore yet another reason why the blog plans to title its Budget Outlook this weekend, ‘Budgeting for Uncertainty’.


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