The following is an excellent excerpt from the book “THE ONLY GAME IN TOWN: Central Banks, Instability, and Avoiding the Next Collapse” by Mohamed A. El-Erian from Part III: “From the What to the So What” from Chapter 17: “Bridging the Gap Between Markets and Fundamentals” on page 126 and I quote: ” The December 2014 episode was particularly revealing of the nature of the codependence that had developed between the Fed and markets. Equities registered one of their largest-ever two-day gains despite a disorderly collapse of oil prices, a currency implosion in Russia, and weaker-than-anticipated data out of China and Europe–again highlighting the extent to which investors’ faith in central banks gave them confidence to shrug off developments that impact more directly fundamentals that determine global economic growth and corporate earnings.
What all this speaks to is the repeated ability of central banks to decouple asset prices from fundamentals. With the related trades working well–after all, one of the most popular investment mantras over the years has been to “never fight the Fed”–investors have been conditioned to respond well to unexpected Fed stimulus almost regardless of the level of asset prices.
While investors as a group have benefited enormously from having central banks as their best friends, not all have been overjoyed, and some hedge fund managers in particular have been quite vocal about their displeasure. Their rhetoric got so loud that central bankers felt compelled to respond, with Richard Fisher, then president of the Dallas Fed, remarking that “big money does organize itself somewhat like feral hogs.” After recalling the epic battle between billionaire hedge fund manager George Soros and the Bank of England in 1992, he added, “I don’t think anyone can break the Fed.”
Hedge funds’ loud and persistent protests reflected the difficulties of investing in markets heavily influenced–and, they would stress, manipulated and distorted–by central banks. With prices and correlations no longer following established analytical and historical patterns, such a situation constitutes a frustrating “structural break” for the models, experiences, and mindsets that have served many of these investors well.
It also drives many of these managers crazy to have central banks participating in markets not just as referees but also as competitors on the same playing field, with a lot better information and a printing press, to boot. It is even more infuriating for them that these referees are willing and able to change the rules at a whim.
Possessing “permanent capital” and a highly elastic balance sheet subject to few constraints, central banks can stick with a “losing trade” much longer than most of the hedge funds can bet against it. After all, they are not commercial players in these markets. As such, extreme market mispricing and irrational correlations among asset classes can easily outlast most hedge funds’ patience. Realizing this, a few well-known hedge fund managers even decided to close their funds and exit the industry–at least for now.
Needless to say, this battle was driven by two very different assessments of what constitutes the right destination. End investors, including pension funds and university endowments, trust their capital to hedge fund managers with the understanding that the latters’ fiduciary responsibility is to pursue profits. Not so for central banks. For them profitable market outcomes are not a destination. It could be part of the journey dedicated to achieving macroeconomic objectives, mostly focused on growth and price stability, but even then, not necessarily so.
Of course, there is some limit beyond which it becomes totally unreasonable to divorce highly elevated asset prices from sluggish fundamentals. The closer you get to this limit–and I believe we have gotten quite close–and the more elusive genuine growth is, the greater the risk of a subsequent disruptive collapse in prices that not only rapidly converge down toward levels warranted by fundamentals but also overshoot them. And the more dramatic the overshoot, the greater the risk that the resulting financial disruptions then undermine the fundamentals.
Academic support for this concern may be found in the work of Michael Feroli (formerly at the Fed and now with JPMorgan Chase), Anil Kashyap (University of Chicago), Kermit Schoenholtz (New York University), and Hyun Song Shin (Princeton University and now the BIS).
Speaking at the well-attended February 2014 U.S. Monetary Policy Forum in New York, which included central bankers, they joined others in warning about the “trade-off between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.” Why? Because their “analysis does suggest that the unconventional monetary policies, including QE and forward guidance, create hazards by encouraging certain types of risk-taking that are likely to reverse at some point.”
Similar worries have also been expressed by the BIS, and not just on unusually low interest rates and exceptional large-scale balance sheet operations by central banks. In a March 2014 paper in the BIS Quarterly Review, Andrew Filardo and Boris Hofmann warned that “if financial markets become narrowly focused on certain aspects of a central bank’s forward guidance, a broader interpretation or recalibration of the guidance could lead to disruptive market reactions.” Reacting that month to a change in forward guidance, Natayana Kocherlakota, president of the Minnesota Federal Reserve, lamented publicly that such an approach could not only damage the central bank’s credibility but also contribute to undermining the economic recovery.
These are also issues that former Fed governor Jeremy Stein took up several times, most pointedly in his powerful May 2014 speech to the Money Marketeers Club of New York University.
Respected for bringing to the Fed a comprehensive understanding of financial developments–one that I characterized as combining “practical market and theoretical economic assessments with insights from both the efficient market literature and behavioral finance”–he pointed to the inherent complexities associated with three realities: “the fact that the market is not a single person, the fact that the Committee is not a single person either, and the delicate interplay between the Committtee and the market.” As such, there is always a risk that “efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating.”
While acknowledging the risks inherent in a policy approach that excessively decouples financial asset prices from fundamentals, defenders of prolonged reliance on unconventional monetary measures point to three potential mitigating factors: an economic liftoff (also known as the attainment of “escape velocity”), where rapid growth would validate what previously were artifically high asset prices; effective “macro-prudential” measures that contain the spillover from excessive risk taking; and, should both fail, a stronger financial architecture and new tools to clean up the financial mess without much contamination to the real economy.
Chair Yellen eloquently spoke to these issues in several speeches, including during her presentation at the IMF in July 2014. In her remarks, followed by a conversation with Christine Lagarde, the institution’s managing director, she acknowledged that low interest rates “heighten the incentives of financial market participants to reach for yield and take in risk,” adding that “such risk-taking can go too far, thereby contributing to fragility in the financial system.”
Having said that, Chair Yellen has often reiterated a firmly held view in the official sector: that, rather than require a change in the monetary policy stance, most of the concerns about bubblish markets would be alleviated by a stronger and durable economic recovery. And to the extent that some may not, they would be mitigated by the use of more robust macro-prudential measures.
Chair Yellen noted that macro-prudential measures, rather than monetary policy, constitute “the main line of defense” against financial excesses–though she would not take “monetary policy totally off the table as a measure to be used when financial excesses are developing.” After all, macro-prudential measures “have their limitations.” Accordingly, she favors keeping monetary policy “actively in the mix,” though “not [as] a first line of defense.”
Undoubtedly progress has been made in strengthening “macro-prudential” measures. Indeed you need only look at the list of accomplishments contained in the July 2014 speech by vice chair Stanley Fischer–which shows the extent to which globally coordinated measures have been supplemented by further Fed actions.
Yet the overall level of effectiveness is yet to be measured properly, let alone tested, and any hope that they indeed will be effective cannot but be increasingly challenged the longer it takes for proper growth to return and the greater the reliance on central banks as the only game in town. Indeed, as Governor Stein noted in that February 2014 speech, “the supervisory and regulatory tools that we have, while helpful, are far from perfect.” It also does not help that, as noted earlier, financial risks are both migrating and morphing.
A similar point was made by Jaime Caruana in December 2014, observing that, “while we now have a sense that all the policies involved need to pull their weight, the truth is that our understanding of how they might interact is still limited.” Caruana noted that especially when the situation is made more complex by macro-prudential and monetary policies pulling in opposite directions, as has been the case in recent years, “gauging the effectiveness of macroprudential policies is another big challenge, especially when more than one tool is deployed.”
Then there is the IMF’s important reminder, which, interestingly enough, comes from a comprehensive staff guidance note that looks at design and implementation issues, including the balance of benefits and risks as well as how to take into account individual country circumstances: “for macroprudential policy to be effective it needs to look beyond banks.”
Finally there is the issue of how, when the time comes to do so, central banks will be able to exit from experimental policies in an orderly and calm manner.
The difficulties were illustrated well in January 2015 by the messy way in which the Swiss National Bank removed an exchange rate floor that it had implemented three years earlier to minimize the damage to Switzerland from the Eurozone crisis. The move came as a complete surprise to markets, triggering the sorts of immediate price moves (including 40 percent in the currency and 10 percent in stocks) that would be notable in developing economies let alone a mature economy like Switzerland known for its stability and predictability.
While highlighting a range of things and leaving several questions unanswered, Switzerland’s bumpy exit is indicative of something that we will develop at greater length in the next two parts of this book and that should be of interest to us all–namely, that the destiny of central banks is increasingly slipping out of their own hands.
How history books end up judging them has more to do with the prospective actions of others than with what the central banks themselves do (though that is not inconsequential). Moreover, to use a gymnastics analogy, I doubt that central banks’ accomplishments will be judged with adjustment for “degree of difficulty.” If they were, their scores would end up quite high. But few will make that adjustment, including politicians, who may well become even more interested in how these powerful institutions carry out their daily functions.”
(THE FOLLOWING IS AN EXCERPT FROM THE INSIDE JACKET COVER AND PRAISE BY KENNETH ROGOFF FOR THIS BOOK AND I QUOTE:
“Widely regarded as one of the most astute observers of global economic trends, Mohamed El-Erian is famous for having coined the now-ubiquitous phrase ‘the new normal.’ Five years ago, he was worried that the global economy might take years to regain its footing. Now El-Erian worries it could fall off a cliff. The Only Game in Town is simply a must-read for anyone trying to understand how the global economy might unfold in the next five years.” ——KENNETH ROGOFF, Thomas D. Cabot Professor of Public Policy, Harvard University, and former chief economist and director of research at the International Monetary Fund
JACKET COVER: “The future, critically, is not predestined. It is up to us to decide where we will go from here as households, investors, companies, and governments. Using a mix of insights from economics, finance, and behavioral science, this book gives us the tools we need to properly understand this turning point, prepare for it, and come out of it stronger. A comprehensive, controversial look at the realities of our global economy and markets, The Only Game in Town is required reading for investors, policymakers, and anyone interested in the future.”
MY COMMENTS: WHEN THE GOVERNMENT GETS REAL REGULATIONS ON THE BIG INVESTMENT BANKERS LIKE SEN BERNIE SANDERS REFERRED TO, THINGS WILL GET STRAIGHTENED OUT. I HOPE HILLARY CLINTON GIVE HIM A CABINET JOB PREFERABLY TREASURY SECRETARY.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran