No respite for investors this year from fear of policy error

Even as surprisingly upbeat economic reports allow investors to reappraise January's global markets selloff, they have failed to dispel anxiety that 2010 may be a year of policy errors.

Soaring fourth-quarter US and Chinese GDP, expanding global manufacturing activity, and even hopes of an improvement in US employment data have helped buoy equities this week, shrunk volatility and generally lifted safe-haven bond yields.

It may be a sign that last month's risk retrenchment, which saw 4.4 per cent stripped off the MSCI all-country world stock index was just a minor blip to remove froth in a bullish market.

But the data is tangential to what many investors consider their biggest risk, that of governments and central banks making a mistake while trying to bring their economic pump-priming policies back to normal.

The fear is that authorities will either move too quickly, stomping on fragile growth, or too slowly, firing up asset bubbles and inflation. And so, while economic data pointing to a fresh slowdown clearly rankles, so too will signs of a sharp acceleration of activity.

The problem with policy errors is that they are likely to be history before their ultimate impact is clear - and some economists believe mistakes are already being made.

Richard Batty, investment director at Standard Life Investments, asks why the US Federal Reserve is ending its purchases of mortgage-backed securities at a time when the crucial US housing market is only just recovering.

The move has the potential to drive up the cost to buyers of getting into the already hard-hit market. "We don't think higher mortgage rates are warranted," he said.

In Europe, meanwhile, the European Central Bank's scaling back of its programme of offering banks cheap money via repurchases is seen in some quarters as having exacerbated the current stress in the eurozone's so-called peripheral economies, particularly Greece.

Since the ECB reduced its role in providing cheap money, Greek, Portuguese and other indebted peripherals' yields have blown out. Greek/German 10-year government bond yield spreads have hit a euro-era record 405 basis points, for example.

Stefan Angle, head of investment management at Swiss & Global Asset Management, said the one-size-fits-all monetary policy needed in the 16-nation currency bloc makes it inevitable that the ECB will make an error.

"It is a 100 percent certainty," he said. "The ECB cannot make the right policy for Greece, Spain, the Netherlands and Germany at the same time."

The policy error dilemma has shown itself perfectly in two quite different nations - slow-growing Britain and red-hot China.

Britain's recovery from recession so far has been the weakest and most fragile of any major economy, with growth of just 0.1 per cent in the fourth quarter. Near-term monetary or fiscal tightening risks cutting off the fuel that has engendered what growth there is.

The Bank of England has nonetheless paused in its programme of buying gilts, potentially forcing borrowing costs higher.

Britain also faces a divisive general election fought in part over when to start cutting back on spending. The Labour government favours holding off for now but the Conservatives, favourites to win, are arguing that some cuts need to be made as soon as possible.

A hung Parliament, one in which there is no majority, is also possible, raising the prospect of political stalemate.

Sarah Hewin, senior economist at Standard Chartered, said that while growth is fragile, it would also be dangerous to do nothing about Britain's deficit of 12.6 per cent of GDP. "The risk of delaying is that markets take fright," she said.

Others have even warned of a sterling crisis.

China, a command economy with double-digit annual growth rates, has no such worries about whether or when to start pulling back the huge stimulus it launched to fight off the global economic downturn.

Rather, the dilemma is over how quickly to do it to avoid overheating, creating asset bubbles and firing up inflation.

"They have increased loans and lending by banks. Potentially, the error is that they have done too much," said Klaus Wiener, head of research at Generali Investments.

Some economists reckon China needs to unwind its stimulus programmes fairly quickly - but markets have been unnerved by the speed and extent of moves China has already made to limit credit growth.

It announced on January 12 that it was raising domestic banks' reserve requirement ratios by 0.5 per cent point, and its largest bank ICBC stopped rolling over some loans last week, triggering a bout of risk aversion among investors.

So, policymakers around the world are struggling to balance the needs of growth against the need to avoid future problems, while keeping an eye on volatile investors who don't want the partial recovery of 2009 to come to nought.

"The potential for policy error is as large as it has ever been in history," Swiss & Global's Angele said.