The ECB, the Fed and the UK – the good, the bad, but who’s the ugly?

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Investors will be watching news like a hawk (but hoping that Draghi is not one!) from the European Central Bank (ECB) today following Mario Draghi’s comments last week that the ECB is prepared to “do whatever it takes” to protect the euro. Opinions are divided on just what they might do, but it seems unlikely the bank will cut interest rates below their current 0.75% level.

The ECB could increase its Securities Markets Programme (SMP), which allows it to buy distressed government bonds. So far it has spent €210 billion on Greek, Spanish, Portugese, Italian and Irish sovereign debt. But Germany is reluctant to allow the ECB to go too far given the significant increase in buying that would be required were it to buy Spanish and Italian debt at the sort of levels needed to bring down yields to a more sustainable level. The SMP could also be combined with the €440 billion EFSF (European Financial Stability Facility) – though over half of this facility has already been spent.

Draghi would dearly love to have unlimited power to buy European sovereign debt, but the political will of Germany seems to be stronger than France and other countries right now. On Wednesday, the German central bank released an interview with Bundesbank President Jens Weidmann, where he said that “politicians overestimate the central bank’s capacity and place too many demands of it”. With European inflation at 2.4%, Germany is worried that unleashing the ECB printing presses together with a weaker Euro could see inflation rising sharply in coming years.

As well as the ECB, markets are digesting the implications of yesterda’y August meeting of the Federal Open Market Committee of the US Federal Reserve. It looks likely that the Fed are ready to act if the US continues to slow but no new stimulus was unveiled right now. The text of the FOMC minutes is as follows:

Information received since the Federal Open Market Committee met in June suggests that economic activity decelerated somewhat over the first half of this year. Growth in employment has been slow in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending has been rising at a somewhat slower pace than earlier in the year. Despite some further signs of improvement, the housing sector remains depressed. Inflation has declined since earlier this year, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

 To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Finally, news today that the UK government seriously considered fully nationalizing RBS (Royal Bank of Scotland) by buying the remaining 18% of the company not in state hands. The price tag would have been around £5 billion. With frustration high that UK banks are continuing to rebuild their capital reserves to prepare for BASEL III instead of lending to consumers and UK businesses, the government seems to have considered any option. The Treasury seems to have vetoed the idea however, but it does smack of desperation.

Quite sensibly UK banks are reducing their risk profile and over lending is not the sensible option. The coalition appears to be clutching at straws to kick start the UK economy out of the double dip recession.  As often stated, the UK continues to be too dependent on services, literally a nation of shop keepers and banks – Tesco is the largest private sector employer, the NHS is the largest public sector employer. A rebalancing will take a lot of time and the question is whether we can wean ourselves of the service sector at all with 80% of jobs in that area. Despite the austerity, it is important to remember that the UK’s national debt is also still rising – much to Mr Osborne’s chagrin…

UK Public sector net debt was £1.04 trillion at the end of June 2012, equivalent to 66.1% of GDP. If all financial sector intervention is included (e.g. Royal Bank of Scotland, Lloyds), the Net debt was £2.31 trillion(147.3 per cent of GDP). Public sector net borrowing was £125.7 billion for 2011/12.

The British economy is struggling and definitive action by the ECB is badly needed to boost the eurozone to avoid pushing the country even further into the mire! As I’ve written before, the world is addicted to stimulus right now.

Contrarian Investor UK

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