US markets: give us liquidity, hold the 'forward guidance'

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With the Dow hitting an all-time high last Friday, markets played a beautiful coda to a trading week which defied vacuous discussions of the U.S. central bank's (Fed) alleged failures to effectively communicate its monetary policies.

Ignoring the chatter, markets cut straight to the key drivers: liquidity and the belief that cheap and abundant credit will continue to support economic activity, job creation and incomes of firms and households.

When in the next few years analysts begin to look again at their rear view mirrors, this past week will most probably be taken as a signal that markets' collective wisdom correctly anticipated the accelerating growth of the U.S. economy.

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And then the usual cohorts of Fed's critics will also note that the bulls on the Big Board ran wild at the time when, following the IMF, America's monetary authorities sharply downgraded economic growth for this year to 2.1-2.3 percent (from their 2.8-3.0 percent forecast last March). One more instance of Fed's wrong analysis, they will say.

I am talking here about a refrain I heard so many times in the past.

I also believe that the current pessimism about America's noninflationary growth potential will eventually give way to a more thoughtful analysis of the economy's ability to expand in an environment of reasonably stable prices.

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Indeed, with steadily improving employment prospects, the civilian labor force could soon reach its long-term trend growth of 1.1-1.2 percent. Adding to that the average labor efficiency gains of 1.4 percent over the last four years would give a potential growth rate of the economy somewhere between 2.5 percent and 3.0 percent.

If these conditions were to prevail, monetary policy would have more room to maintain an accommodative stance. The Fed would also have more time to correct the excesses created with extraordinary efforts to support the gravely damaged financial system and to prop up an economy struggling to recover from the Great Recession.

Restrictive fiscal policy will help, too, by providing additional space for monetary flexibility. This year, the expected federal budget deficit of 2.8 percent of gross domestic product (GDP) would be one-third less than the shortfall in the previous year and would fall below the 3.1 percent average over the last 40 years.

Don't rain on bulls' parade

That is a significant achievement, but further efforts will be necessary to stop and reverse the growth of America's gross public debt. At this writing, the U.S. National Debt Clock stood at $17.5 trillion, or 102.3 percent of the nominal GDP, based on the economy's first quarter numbers.

Clearly, American monetary and fiscal policies are facing difficult tasks at the time when the economy is trying to stabilize and move onto a higher growth path.

The Fed's support and stable financial markets are crucially important. That, however, will be a tough act to play at a time when the Fed wants to exit from unchartered territory it created with its crisis, and post-crisis, management.

By comparison, the fiscal policy is way ahead in its recovery from massive bailouts, even though there is still quite a bit of work to do. For example, this year's estimated primary budget deficit (deficit before interest payments on public debt) of about 2.5 percent of GDP should rapidly move toward a period of sustained surpluses to begin a reduction of an unacceptably high public debt.

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But whether the U.S. political leaders will be able to work together to see that through while fighting each other in the key electoral contests -- mid-term Congressional elections next November and presidential elections in 2016 -- remains to be seen.

Given the current political climate, odds are not high that they might be able to do that.

That is unfortunate, but I believe that an easier political consensus may be found about the management of current geopolitical crises that present serious and immediate risks to the economy and financial markets.

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Avoiding foreign military entanglements, theater mission creeps and bruising sanction wars will be essential. The latest opinion polls (on Iraq, for example) indicate that the American people don't want any of that. With two important elections ahead, politicians will hopefully listen and try to use the "soft power" to lead-manage on issues of international peace and security. Some call that the "smart power." But, whatever the name, that approach would be more productive than dangerously intractable confrontations with nuclear-armed adversaries.

Investment thoughts

The Fed's firm commitment to easy monetary policies for the foreseeable future bodes well for U.S. equity markets. I, therefore, see no reason to change my long-held view favoring stocks in a clear preference to fixed-income assets.

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Don't be distracted by the furious debate about the Fed's "forward guidance" and by the cacophony of perhaps intentionally confusing statements coming from various monetary officials. The Fed's policy is data driven. So, watch the data on growth, jobs and inflation if you want to correctly guess what the Fed will do next. Need a shortcut? Watch this column.

But do monitor carefully the volatile geopolitical situation. Problems in Iraq and in Central Europe can send energy prices soaring to levels that might kill Europe's recovery – and one-fifth of U.S. exports with it – to say nothing of dangers that would pose to energy-starved East Asian economies.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9