The Federal Reserve weighs in again this week on the price of money. Functionally, nothing’s changed. It’s just one more summit on engineering an interest rate that a select group of Fed officials see as optimal. But measured by the context of the current global economy, the stakes in this week’s decision on the Fed funds rate are higher than before. In fact, that progression of an ascending ante promises (threatens?) to hold fast for the foreseeable future FOMC confabs.
For the one that arrives on this Wednesday and Thursday, the pressing question turns on where to err? On one side is the preference for nipping inflation’s momentum of late by elevating interest rates yet again, and thereby risking an economic slowdown of greater magnitude than would otherwise unfold. The alternative (which still appears out of favor but nonetheless within the realm of possibility) favors growth by keeping Fed funds at the current 5.0%. In theory, a third choice beckons: cutting rates, but almost no one believes this one’s a viable choice at the moment.
Deciding where the path of greatest prudence (or minimal recklessness) lies rests largely on how one sees or ignores the risks that lurk in the global economy. The Bank for International Settlements (the so-called central bank for central banks) last week handicapped the future on this score by opining that “the best bet for next year is that strong, non-inflationary growth will continue,” according to the new annual report for BIS. If so, the Fed’s job will be infinitely easier by widening the margin for error considerably in matters of monetary policy.
But even an optimistic take on what comes next shouldn’t ignore what might go wrong, and the new BIS publication lays out the range of possibilities with clarity. Summarizing the yin and yang of outcomes that may arrive in global economics boils down to the BIS advisory “there are considerable uncertainties and associated risks, not least concerning inflationary pressures on the one hand, and a possible unwinding of accumulated economic and financial imbalances on the other.”

To be precise, and somewhat narrowly focused, one could argue that the savings deficit that prevails in the United States relative to the accumulated cash on China’s balance sheet constitutes the great global financial imbalance of the moment. Clarity on what it means is in short supply, but there is a surfeit of questions that pester and pursue the otherwise unapologetic optimist. To cite just a few of the inquiries for which there are, as yet, no definitive answers:
* Is the great imbalance destined to correct?
* If so, will the correction come quickly or unfold over years or even decades?
* What might the implications of a correction be?
* How does one’s decision on the aforementioned questions inform an enlightened asset allocation policy?
Invariably, one’s risk tolerance, investment horizon and financial goals should provide the primary guidelines for crafting a portfolio strategy. On that score, ours is one of erring on the side of caution, a decision that’s supported by our reading of valuation levels in the major asset classes, which is to say, nothing looks particularly compelling on an historical basis. Cash and short-dated bonds, as a result, have the edge in our strategic thinking these days. That may prove to be painfully wrong, but for the moment we’re willing to assume the risk. Correcting the global imbalance, if it comes in its most-potent form, would mean, among other things, a sharp drop in the dollar and a commensurate rise American interest rates. The odds of that happening may be low. But since we’re inclined to preserve wealth at the expense of growing at the current juncture, ours is defensive posture. So be it. We’ll take whatever lumps will follow, but at least we’ll be sleeping soundly.
More importantly, the world awaits the Federal Reserve’s inclinations on weighing risks. With the Bernanke era not yet six months old, the capital markets are still assessing how the Fed chairman thinks and acts. Of particular interest is the question of how the former Princeton professor evaluates the great imbalance relative to the prospects for an economic slowdown and higher inflation. In the recent past he’s embraced a wide latitude of explanations that might affect his thinking on policy. But the miracle of the “savings glut” argument of a few years back has been replaced by tougher talk on inflation, and so one could argue that the evolution of Ben has removed some of the mystery surrounding his outlook.
But FOMC meetings speak louder than words. The future’s uncertain, although it arrives in convenient daily packages, sprinkled with clues and the occasional flavoring of obfuscation. The next installment arrives on Thursday. Aloha!