End of NICE decade is rude shock for investors:James Saft

The demise of the NICE decade of low inflation and steady growth, mourned by Bank of England Governor Mervyn King, means tough times are ahead for most financial assets.

Calling it the "most difficult challenge yet" for Britain's 11-year-old Monetary Policy Committee, King last week declared the decade of non-inflationary consistent expansion (NICE) over and done, as tight credit and rising inflation force a rebalancing from consumption and borrowing to production and savings.

That is bad news for King and Britain, as the bank will have little freedom to ease the economy's transition by lowering interest rates.

But it will be bad news for financial markets as well, and not just in Britain. Inflation and economic growth will be choppier and less predictable, and so therefore will be company profits.

And if there is one thing investors hate, quite rightly, it is unpredictability. They will react, almost mechanically, to this new volatility by demanding an extra risk premium for holding stocks and bonds.

That extra premium implies, all other things being equal, lower prices for the same earnings power in a stock or a bond.

"We are at the start of the decade of great instability for both real economies and asset markets," said Lena Komileva, an economist and strategist at brokerage Tullett Prebon in London.

"At a time when the cost of finance is decided in asset markets, outside the control of central banks, increased macroeconomic instability and rising asset price volatility as a result will compound the effects of the credit crunch.

"With cheap leverage no longer available, an adverse macroeconomic environment will make the correction of asset valuations in line with real fundamentals that much more painful."

The NICE decade is a manifestation of the broader phenomenon that economists have dubbed the Great Moderation.

Since the 1980s the economies of the West, led by the United States, have enjoyed fewer and less severe downturns, a period characterized above all by less volatility in the economy both in terms of growth and inflation.

There has been a lot of debate about what caused such an extended period of predictability, but what is clear is that the benefits have been huge. It has made it easier for governments, companies and individuals to plan their investment and consumption.

It has also probably contributed to a fall in savings in the English speaking economies, as rainy days have been few and far between.

All that seems to be changing.

THE HIGH VALUE OF PREDICTABILITY

If the Great Moderation is on the way out, investors will simply have to get used to more volatility.

To get a sense of how important this is, look at the premium investors paid for General Electric shares during its period of steady earnings expansion. Or conversely, look at the very low multiple of earnings shareholders are willing to pay to hold investment banking shares, which historically experience huge volatility in earnings.

And though Britain has gone longer without a recession, there is no doubt that the United States has also benefited from low and stable inflation and is now seeing rising inflationary pressure.

More than 20 percent of Britons polled in a survey by the Bank of England and GFK expect inflation to rise by five percent or more in the next year.

In the United States, the Reuters/University of Michigan survey of consumer sentiment, released on Friday, showed that median year-ahead inflation expectations jumped to 5.2 percent in May from 4.8 percent in April, the highest since the dark days of February 1982, when inflation was raging and the Great Moderation just a gleam in Paul Volcker's eye.

The latest bout of inflation is being caused by skyrocketing prices for agricultural commodities and energy. And whereas emerging markets like China were only one or two years ago supplying disinflation to the west through competition and cheap manufactured goods, these countries are now themselves in the grip of rising wages as well as commodity prices, making them a source of inflation.

Russell Jones, a fixed income strategist at Royal Bank of Canada in London, thinks that rising volatility won't just hit asset prices across the board.

"Volatility also heightens risk aversion as well," he said. "People are frightened off by volatility and they will keep their money in less risky asset."

Jones thinks Britain faces a period he characterizes as "evil," for Exacting period of Volatile Inflation and Low growth.

Quite possibly it won't be that bad, but two things are reasonably sure: central banks will not have the same freedom to lower rates they have used in the past to dampen economic volatility, and investors will have to grapple with the costs.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

What the Fed is considering at its meeting

The Federal Reserve looks set to deliver a small interest rate cut on Wednesday to help an economy moving sideways at best and could signal the move is the last in a cycle as officials eye inflation warily.

The Fed has already cut interest rates to 2.25 percent from 5.25 percent in six steps since mid-September in an effort to keep U.S. economic activity going in spite of a credit crunch and a deep housing downturn.

Food, fuel and raw material prices are rising, boosting inflationary pressures, a Fed report said recently.

"This meeting's accompanying statement poses a special challenge for the committee justify easing another quarter point to avoid a deeper recession, and simultaneously acknowledging the risk of commodity inflationary pressures," RBS Greenwich Capital analysts David Ader and Ian Lyngen said in a research note.

Interest rate futures prices imply about an 80 percent probability of a further quarter-point reduction and about a one-in-five chance of no move at all when the Fed wraps up a two-day meeting on Wednesday.

The government reports on first-quarter U.S. gross domestic product on Wednesday. Economists polled by Reuters expect the economy expanded at a sickly 0.2 percent annual rate, which would be the weakest since the closing months of 2002.

In addition to cuts in benchmark rates, the U.S. central bank has unleashed a series of emergency measures, sometimes in coordination with other central banks around the world, to keep banks and major financial firms lending and borrowing. In a dramatic intervention last month, it stepped in to prevent the failure of wounded investment bank Bear Stearns .

With some signs financial markets are stabilizing, Fed officials expect the combined effects of rate cuts and a $152 billion government stimulus package to revive the economy.

They are likely to discuss whether borrowing costs are appropriately positioned to aid recovery without fostering inflation. Their statement will provide clues to the tone of that debate.

Following are some factors Fed policy makers will be considering on Tuesday and Wednesday:

LIQUIDITY: Fed officials are worried about continued signs of strains in short-term funding markets, as evidenced by elevated risk premiums institutions are continuing to pay. Elevated spreads between the London Interbank Offered Rate, a gauge of what banks charge each other for loans, and overnight indexed swaps, a measure of anticipated central bank interest rate targets, fuel those concerns.

Policy-makers have offered more than $400 billion in liquidity to banks and primary dealers in Treasury securities, and suggest they are ready to bring more liquidity measures to bear if necessary to restore normal market functioning.

INFLATION: Fed officials are hearing from their contacts around the country that food, fuel and raw material prices are rising and contributing to inflationary pressures, the central bank's Beige Book survey released on March 16 showed.

Also, two members of the Fed's interest-rate setting committee voted against the March decision to cut rates by a sharp three-quarters of a percentage point, preferring less aggressive action and citing the potential for higher inflation -- and higher inflation expectations as a worry.

But other Fed officials believe that higher-than-desirable levels of inflation will not persist as the slowing economy raises unemployment levels.

RECESSION WATCH: The economy is growing sluggishly and possibly even contracting. Of most concern to policy-makers is evidence from measures of confidence that the slowdown is driven by a retrenchment in consumer spending, rather than in business investment.

However, Fed officials' chief concern is that growth could brake more than expected. Gloomy consumer sentiment could feed a sharper slowdown and persistently tight credit could neutralize the effect of Fed rate cuts in providing a boost to economic activity.

Finally, housing markets remain very weak. But policy-makers expect those doldrums to lift over the course of the year and look for housing to exert less of a drag on economic growth in coming quarters.

RECENT COMMENTS:

Dallas Federal Reserve Bank President Richard Fisher, April 22: "It's really a question of, are we getting the bang for the buck (from interest rate cuts). And clearly we're not. The system is sputtering."

Philadelphia Fed President Charles Plosser, April 18: "A slowing economy is no guarantee of slowing inflation pressures. The role of monetary policy is to ensure the stability of the purchasing power of the nation's currency, so that markets are not distorted by inflation. To insure the credibility of monetary policy we should never ask monetary policy to do more than it can do."

Fed Chairman Ben Bernanke, April 2: "Overall, the near-term economic outlook has weakened relative to the projections released by the (Fed) at the end of January. It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly.

"We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies; and growth is expected to proceed at or a little above its sustainable pace in 2009, bolstered by a stabilization of housing activity, albeit at low levels, and gradually improving financial conditions. However, in light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high and the risks remain to the downside."