Investment Views, February 2012

Investment Views is a well-informed, simple to read, monthly analysis of markets, currencies and economies.

THE LAW OF DIMINISHING RETURNS

Wikipedia gives a good example of the law of diminishing returns when it uses the analogy of adding fertilizer to a crop.  The use of fertilizer improves output to a point, but adding more and more improves crop yields by ever smaller increments and excessive quantities can eventually even reduce the yield.  On January 25, The US Federal Open Market Committee, led by Chairman Bernanke, began its latest exercise in what it calls “transparency”. It is our view that the FOMC, far from having many tools at its disposal to address weakness in the US economy, has little spare capacity to influence the growth path in the US, the trend in long-term interest rates or the direction of risk assets.

First of all, we should address what we believe the Fed’s release actually said in late January and what it means for policy. Press reports and many analysts have simply stated “the Fed is on hold until late 2014”. The actual text and press conference wording show a different result and therefore a different interpretation. The timeframe of late 2014 was actually the median tendency of Fed Governors, not a commitment to zero rates until that time, nor was it a unanimous conclusion. Several Governors had earlier tightening in mind and several had a view that tightening was even further off in the future, with a range of outcomes for the Fed Funds rate in 2014 between 0.25% and 2.75%! Our interpretation of this is that there is a huge distribution of potential possibilities, between near-term normalisation of base rates and a Japanese scenario of zero policy rates ad infinitum. This neither gives us confidence in interest rate market direction, nor does it give us a clearer picture that the Fed has many tools at its disposal, which they unanimously believe will actually work to stimulate growth.

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