Early enough in my career in research somebody told me I focused too much on how things should be as opposed to how things are likely to be. Clearly, when in the business of mapping reality to asset prices, what it should be is less relevant than what it is likely to be. For many years now I have written mostly about likely scenarios. But the current debate on US monetary policy merits a little sin of thinking what it should be, since it is a good guide of what is likely to be.

Last week the Fed released the minutes from its last FOMC meeting, which revealed that a larger group within the committee is concerned about the effects of monetary expansion and the mechanics of a withdrawal. That obviously spooked the markets, despite the fact that it should be obvious to all that the current unprecedented monetary expansion is not forever.

Our skepticism about the merits of monetary policy with respect to normal business cycles has been stated many times before. We believe that when monetary policy turned decisively and massively easy in early 2009 it did most of the stabilization job, as it does have the power to shock a system in disarray and coordinate expectations. But monetary policy cannot create growth, and this is the problem with the current market addiction with large and growing central banks’ balance sheets.

As economic data started to show a world in the mending in the last 2-3 months, it is natural to expect policy makers to start thinking about their exit strategies. Trial balloons like the Fed minutes are discreet events that scare markets, but any exit strategy is bound to be slow and gradual, coinciding with better growth. Even if inflation recovers faster than growth, policy makers are bound to tolerate inflation (which coincidentally helps on the fiscal side) and withdraw gradually. Thus, the future holds what it should hold. Fiscal tightening has become a reality recently, and gradually we need to get used to monetary expansion reversing itself. Both have been used to unprecedented degrees for contemporary markets history, which means a higher sense of uncertainty than otherwise.

However, markets believe what they believe. Despite the fact that we all know monetary expansion cannot stay forever, and that G7 countries need to adjust their fiscal balances in order to avoid debt crises, markets over-react to the mere debate about monetary policy moderation.

As we wrote a few weeks ago, steps towards fiscal sustainability are positive, and the same applies to monetary policy normalization, especially since they are bound to be gradual and on the late side (as Bernanke just confirmed in its senate hearing, when it hinted that the Fed would not sell assets but would let them expire through time). A medium-term perspective calls for staying the course, and use these scares to reallocate to real assets. This is obviously easier said than done, especially when each downdraft brings new risks (like yesterday with Italy’s elections). All this confirms the cautious stance, where the exposure to real assets is being increased only gradually, starting from a conservative position.

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