Central bank support paves way for progress

We shouldn’t be surprised by the shift up in optimism, given that global central banks, most importantly the Fed and the ECB, are continuing to push easier monetary policy in a way that is, at least in the short term, offsetting the de-leveraging pressure that was building in the global financial system.

Thus, we have the ECB’s big provision of liquidity clearly stabilizing funding markets and buying time for European policy makers to sort through the big questions hanging over Europe. Then on Wednesday the Fed made it clear that it expects to keep policy rates easy for a long time (extending its announced expectations of “exceptionally low interest rates” into 2014).

In addition, Fed Chairman Bernanke was explicit that he will consider further quantitative easing, stating that “it’s an option that’s certainly on the table”, if the recent strength in growth does not continue. This statement suggests that the Fed has become more comfortable with quantitative easing as just another tool in the money policy armory along with interest rates, rather than seeing it as a discrete emergency measure.

These moves by the ECB, the Fed and also the Bank of England are important steps in assisting liquidity, and certainly reduce the probability of disorderly de-leveraging and near term collapse of Euroland.

Liquidity is vital and the recent deterioration in growth rates at the periphery has come as a result of the significant tightening of liquidity and deterioration in market conditions prior to the more substantial ECB easing of the last few months.

But it is still too early to know to what extent this easing will arrest the sharp contraction in the periphery, and while increased liquidity to the banks should help, it still does not address the high levels of indebtedness, over-consumption and lack of competitiveness. Thus, we must be clear that given that the debt and debt service challenges and the imbalances persist, the easing has deferred rather than cancelled the crisis.

Specifically for Euroland, there are series of key questions as yet unanswered. For instance, it’s not clear who will recapitalize the banks. On the issue of the EU and ECB’s policy tools, there’s a recognised lack of appropriate fire power, and therefore questions as to whether the ESM should be brought forward and with what capacity and whether and how the EFSF can be levered effectively. Most immediately in the minds of many market participants is the uncertainty surrounding the burden to be shouldered by the private sector in restructuring Greek debt, and by extension how restructurings will be dealt with by the EU and ECB. Then there is the uncertainty as to the role and support that may be provided by the IMF.

On top of these challenges there are the steps with long term focus that must be put in place to avoid the problems re-building. We do have the fiscal harmonization policies agreed in principle in December at the EU Summit, but these must be passed at the country level. There is the additional complication that in a market system, the response of the market to actions taken is important – and actually quite hard to read.

Taking all these factors into account, central bank support of liquidity is very helpful – but it’s insufficient to sustain market progress, if there is no growth follow through and no resolution of the imbalances.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla