Are central bankers dancing to the markets' tune?
Markets and banks are kept afloat not so much by past QE but by the expectation that central banks will double up on it if markets should collapse again. Have asset prices become de facto the new monetary standard? From a longer-term perspective, and contrary to conventional wisdom, this could be a move in the right direction – but it has been taken in an uncontrolled fashion that heightens the risks involved in such a regime change.
The risk is that speculators have, in effect, taken central banks hostage. Certainly, market participants want monetary policy to remain sufficiently expansionary to keep asset prices rising – or at least prevent them from falling steeply. If unemployment falls in the process, so much the better, but for markets that is an accidental by-product. It is awkward for central bankers like Mark Carney, who has somewhat rashly linked monetary policy in the public’s mind with a specific unemployment rate. Now it has almost reached that 7% threshold, he is having busily to think up other reasons to keep the monetary floodgates open. But each new wave of central bank activism muddies the line between their technical monetary activity and a political/ fiscal role. Central bankers extend such policies knowing that they are increasing the fear in markets that they might not be able to pull back from their over-extended positions. That is why they are wont to talk, misty-eyed, of a gradual change in policies and progress towards normalisation taking place over years rather than months.
That ‘s also why current policies progressively undermine the viability of monetary policy itself. At present, developed country markets are worried about a new downturn, beset by fears of excessive public and private sector indebtedness, of a meltdown in EM economies or a liquidity squeeze in China. They are sustained by expectation of further – and if necessary expanded – central bank liquidity injection. The longer QE lasts the more difficult it will be for central banks to unwind their positions and reduce their balance sheets without triggering the mother of all asset price crashes and inflicting new damage on the economy. Thoughtful central babkers appreciate that sustained manipulation of long as well as short-term rates is inconsistent with capitalism; yet that is what we are seeing and it seems likely to continue – not just for ‘political’ but also for ‘market’ reasons. Thus nobody knows what the equilibrium, natural or true market rate structure really is. Of course this inability to calculate the true cost of capital holds back and/or seriously misallocates new capital investment. That is partly why the recovery feels so fragile.
Recent tremors in stock markets – after a long bull run – signal that it may be time to reduce the proportion of one’s portfolio in equities. Yet, at the same time, long-term yields are likely to rise further. For investors, does this point to the need to increase the allocation to short-term government and corporate bonds? How about: 10% cash, 50% short (1-5 year) gilts, US Treasuries and euro/US$ corporate bonds (you can get a 5% flat yield if you include some high-yielding bonds), 30% equities and 10% gold. Then move into long-term gilts and US treasuries when 30-year yields hit 5%? (I hasten to add that I am not an investment adviser, merely airing thoughts to focus the discussion).
What to do about the boom in some asset markets in some economies? Constructing an index of asset prices is notoriously difficult. Yet it could be a way to monitor and check such a boom – which, if it were to gather steam and then crash, could well bring down the real economy and many banks with it – again. Central bankers talk of fixing these risks with new tools of macro-prudential policy – such as loan to value ratios and other physical controls. I hope that economists with a sense of history will point out that these have a very uneven record of achievement; they can easily become instruments of financial repression; they failed in the post-war period, at high cost; that they are in the long run incompatible with free markets; and – as they will vary from one country to another, risk splintering the global financial system further. In other words, they are at best temporary fixes. There is no alternative long run to controlling the growth of money itself. The open question is what the monetary anchor is to be.
As long as governments and central bankers duck such basic questions, there will be no long-term solution. 2014 will be another year of staggering on. It is precisely the absence of a credible monetary strategy for the longer term that deters a healthy recovery from taking hold in the short term. Without such a strategy, the central bankers will indeed dance to speculators’ tune.
Read the next exciting episode.
Prospects for 2014
Are central bankers dancing to the markets' tune?
Markets and banks are kept afloat not so much by past QE but by the expectation that central banks will double up on it if markets should collapse again. Have asset prices become de facto the new monetary standard? From a longer-term perspective, and contrary to conventional wisdom, this could be a move in the right direction – but it has been taken in an uncontrolled fashion that heightens the risks involved in such a regime change.
The risk is that speculators have, in effect, taken central banks hostage. Certainly, market participants want monetary policy to remain sufficiently expansionary to keep asset prices rising – or at least prevent them from falling steeply. If unemployment falls in the process, so much the better, but for markets that is an accidental by-product. It is awkward for central bankers like Mark Carney, who has somewhat rashly linked monetary policy in the public’s mind with a specific unemployment rate. Now it has almost reached that 7% threshold, he is having busily to think up other reasons to keep the monetary floodgates open. But each new wave of central bank activism muddies the line between their technical monetary activity and a political/ fiscal role. Central bankers extend such policies knowing that they are increasing the fear in markets that they might not be able to pull back from their over-extended positions. That is why they are wont to talk, misty-eyed, of a gradual change in policies and progress towards normalisation taking place over years rather than months.
That ‘s also why current policies progressively undermine the viability of monetary policy itself. At present, developed country markets are worried about a new downturn, beset by fears of excessive public and private sector indebtedness, of a meltdown in EM economies or a liquidity squeeze in China. They are sustained by expectation of further – and if necessary expanded – central bank liquidity injection. The longer QE lasts the more difficult it will be for central banks to unwind their positions and reduce their balance sheets without triggering the mother of all asset price crashes and inflicting new damage on the economy. Thoughtful central babkers appreciate that sustained manipulation of long as well as short-term rates is inconsistent with capitalism; yet that is what we are seeing and it seems likely to continue – not just for ‘political’ but also for ‘market’ reasons. Thus nobody knows what the equilibrium, natural or true market rate structure really is. Of course this inability to calculate the true cost of capital holds back and/or seriously misallocates new capital investment. That is partly why the recovery feels so fragile.
Recent tremors in stock markets – after a long bull run – signal that it may be time to reduce the proportion of one’s portfolio in equities. Yet, at the same time, long-term yields are likely to rise further. For investors, does this point to the need to increase the allocation to short-term government and corporate bonds? How about: 10% cash, 50% short (1-5 year) gilts, US Treasuries and euro/US$ corporate bonds (you can get a 5% flat yield if you include some high-yielding bonds), 30% equities and 10% gold. Then move into long-term gilts and US treasuries when 30-year yields hit 5%? (I hasten to add that I am not an investment adviser, merely airing thoughts to focus the discussion).
What to do about the boom in some asset markets in some economies? Constructing an index of asset prices is notoriously difficult. Yet it could be a way to monitor and check such a boom – which, if it were to gather steam and then crash, could well bring down the real economy and many banks with it – again. Central bankers talk of fixing these risks with new tools of macro-prudential policy – such as loan to value ratios and other physical controls. I hope that economists with a sense of history will point out that these have a very uneven record of achievement; they can easily become instruments of financial repression; they failed in the post-war period, at high cost; that they are in the long run incompatible with free markets; and – as they will vary from one country to another, risk splintering the global financial system further. In other words, they are at best temporary fixes. There is no alternative long run to controlling the growth of money itself. The open question is what the monetary anchor is to be.
As long as governments and central bankers duck such basic questions, there will be no long-term solution. 2014 will be another year of staggering on. It is precisely the absence of a credible monetary strategy for the longer term that deters a healthy recovery from taking hold in the short term. Without such a strategy, the central bankers will indeed dance to speculators’ tune.
Read the next exciting episode.
Written on January 26, 2014 at 10:06 pm, by robert
Categories: Banking, Homepage, Official Money, RP's Diary