The $1 trillion injected by the Federal Reserve into the financial system over the past two-and-a-half years is like toxic nuclear waste locked up in concrete casks or at Yucca Mountain.
That’s the view of Tony Crescenzi, chief strategist at Pacific Investment Management Co. (PIMCO), who addressed more than 350 financial professionals in downtown Minneapolis last night.
“People worry about the Fed printing money and what it could do to inflation. If you watch CNBC all day, you see commercials urging people to buy gold coins,” he said.
“No doubt about it. It can cause a lot of inflation. But it won’t until it’s lent … As long as the banks that received the funds continue to sit on them and not lend them out, the risk of inflation is low,” he added.
Criscenzi was speaking at an event co-sponsored by the local chapters of the Chartered Financial Analyst (CFA) Society, the National Investor Relations Institute (NIRI) and the Association for Corporate Growth (ACG).
He also takes seriously the Fed’s commitment to hold interest rates at or below 2 percent. His firm expects inflation to pick up in two to three years, but “not meaningfully for a while … The Fed has made it clear; they will not tolerate inflation above 2 percent,” he said.
And that formulation aptly describes the delicate dilemma the economy faces in fiscal and monetary conditions as it emerges from the worst downturn in 80 years.
Despite the tight credit environment, Crescenzi is nevertheless more bullish than many in his outlook for the U.S. economy. In a year-end note to clients, he predicted that improving employment, particularly in the service sector — combined with accelerating business investment in technology, plant and equipment and a slow return of consumer confidence — “will lead the U.S. economy to a self-reinforcing virtuous cycle of increases in production, income, and spending” in 2011.
(Crescenzi’s analogy of the Fed to Yucca Mountain ignores the fact that no nuclear waste is stored there, and further development of the site as a repository has been halted. Nonetheless, it’s a colorful and easily grasped metaphor that I think works for its intended purpose.)
“When the money starts to leak out, the Fed will have to start to drain it, because it’s toxic,” he said. While they can pull “a couple of hundred billion” out of the system by trading dollars with banks, “at some point they’ll have to raise interest rates.” As that happens, markets will anticipate increasing interest rates a few months out, which will affect bond yields.
Some cracks may be showing already, but Crescenzi is not concerned, yet.
He said that banks have started to lend again and have eased up on commercial lending standards “for the first time in several years.” Commercial and industrial loans have picked up in the past two months, “the first increase in two and a half years,” he said.
But Crescenzi said that lending activity will not have an impact on inflation. Even when lending activity does pick up further, “there is a two-and-one-half-year lag between increased money supply and inflation,” he said.
Crescenzi said U.S. Treasuries will remain the benchmark risk-free rate. “The U.S. cannot default in theory, because it can print money. It means more inflation.”
He added: “The most important thing that has to happen this year is to raise the debt ceiling. That’s highly likely… probably around 2 a.m. when you’re not watching CSPAN.”
Asked to rate the performance of Federal Reserve Chairman Ben Bernake, Criscenzi gave him an A+ in keeping the Fed’s focus on the core inflation rate. “I absolutely think he’s done an excellent job. Look at how he’s above politics and look at the man. He seems to be a man who genuinely cares about people.”
He told the audience that the era of simply buying 30-year Treasuries as a successful investment strategy is over. He recommended that investors become more selective about choosing bond investments based on credit quality, yield, country and risk.
“The new normal is understanding that the world has changed and you have to drop your home bias,” he said, urging investment in emerging markets. He also said investors need to understand that “the government is not just a referee, but a player,” in the financial markets by issuing large amounts of debt.
He predicts that the dollar will remain weak, as investors diversify into other currencies.
While the U.S. dollar is losing about one point of market share per year as the reserve currency of choice globally, primarily to the euro, he’s not overly concerned. “So long as it’s not rapid and disorderly … it doesn’t mean much to stock investors.”
He also said the default risk for most state and local government bonds has been overstated. He predicted 100 or fewer defaults this year, mostly among very small issuers. “You’ve got to put your fears aside. When others are selling, we should be buying.”