Aren’t central bankers supposed to provide stability rather than enhance chaos theory?

Yesterday came an example of one of the flaws in the world economic structure and indeed in financial markets. In response to testimony by the Chairman of the US Federal Reserve Ben Bernanke financial markets surged and then plummeted. If we look at the Dow Jones equity index we saw it rise by 150 points and then fall by over 200 to close a net 80 points lower at 15,307. This pattern was pretty much repeated in the US government bond market where there were price rises followed by a sharp drop. The drop was enough to push the ten-year yield above the 2% barrier as it closed at 2.03%.

What did Ben Bernanke actually say?

Here is the section which led markets to rally and surge.

Unfortunately, withdrawing policy accommodation at this juncture would be highly unlikely to produce such conditions. A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.

This hit an atmosphere where there have been rumours for a while that the US Federal Reserve might be planning to reduce the US $85 billion per month of Quantitative Easing it currently undertakes. As you can imagine an apparent rejection of this by Ben Bernanke was news indeed and financial markets shot higher. Indeed such thoughts got backing from a deeper reading of the report as whilst we know that the Federal Reserve is targeting the US unemployment rate (aiming for 6.5%) we also got a hint that it might also look at wider measures such as underemployment.

Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly:

So one might reasonably expect at this point that we were being told that what is called QE Infinity was ongoing and no changes were planned.

However once the prepared testimony was over Ben Bernanke said this in response to a question.

If we see continued improvement and we have confidence that that is going to be sustained, then we could in the next few meetings … take a step down in our pace of purchases.

It was only yesterday that I was discussing the future Governor of the Bank of England Mark Carney talking out of both sides of his mouth at the same time! Here Ben Bernanke is doing the same in the United States but his latter remark was later reinforced by the minutes from the latest Federal Reserve meeting.

A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth.

What is the role of a central bank?

I would argue that the major role of a central bank is to promote stability and certainty in an economy. For example in inflation, interest-rates and confidence in financial markets. In its Statement on Longer Run Goals the US Federal Reserve apparently agrees with me.

clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertain­ty,

enhances transparency and ac­countability, which are essential in a demo­cratic society

Yet yesterday its Chairman did exactly the reverse and increased uncertainty and his testimony was not transparent and was rather misleading. This is compounded by the way that central banks have expanded their balance sheets and activity meaning that they trample around financial markets like gorillas and woe betide anything in their path. So financial markets await news of their likely moves like a new drug for a sick patient and we arrive at the result which is a central bank causing instability rather than stability in what I feel is a perversion of their true role.

Also I do not know about you but I am am weary of the homilies about “democratic society” from unelected organisations which in reality resemble a dictatorship. For newer readers I have argued for some time for an injection of democracy into the Bank of England as members of its Monetary Policy Committee have far more power than ordinary MPs and frankly many cabinet ministers.

Any exit strategy will be too late

One thing we can be clear about is that any “exit-strategy” (from all the monetary expansionism such as QE) will be delayed and be too late. I have thought this since such measures began as central banks will want to be sure of any recovery before acting and as any data is lagged they will be too late. The use of a measure which is very lagged such as the unemployment rate simple confirms this and makes it a certainty.

So monetary expansionism poses quite a few challenges for any recovery as well as issues now which again has them acting as agents of instability rather in their proper role of providing stability.

Chaos theory

This has been based around the question below.

Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?

If we see that central banks are far more powerful than a butterfly’s wings then adherents to such a theory will be worried about the consequences of their actions. They will expect them to spiral through economies and be very dangerous. This will led to worries that the (unintended) consequences will mean that such policies make things worse and not better.

Last night

I was wondering about this concept last night as of course Japan is plunging even further into the world of monetary easing. I cannot make any claim to full prescience as I was thinking of the consequences of what had happened for  Japanese Government Bonds. Whereas the news headlines today concentrated on this. From the Financial Times.

Nikkei plunge sparks global market retreat

The Nikkei 225 equity index fell by 1143 points or over 7% overnight to 14,483. The swing on the day was even larger than this as it has rallied at the opening passing 15,900 at one point. So it was a wild ride following what have been large gains in 2013 so far as it is still up by some 40% overall.

Problems for central planners

Actually my worries did come true as at the opening in Japan government bond price fell heavily and the ten-year yield nearly touched 1%.  This in itself would have provoked worries about Japanese banks who are large holders of them.

However then we saw an example of a butterfly’s wings fluttering over China.

Flash China Manufacturing PMI™ at 49.6 (50.4 in April). Seven-month low.

So a downwards nudge from China on an uncertain situation saw all financial markets in Japan become very volatile. The equity market plunged which in itself may have helped the bond market but also the central planners were back also as the Bank of Japan stepped in with what Governor Kuroda calls “flexible market operations”.  Both bond and equity market futures closed for a time but in spite of this cash equity volumes were a record.

Remember too that the Bank of Japan does buy equities via exchange traded funds and we can expect it to have been active this morning too.

Comment

It was only on Monday that I discussed the economic policy called Abenomics in Japan and pointed out that the week had started with price instability in several markets.

This morning has already seen plenty of action in the markets of the Far East with the price of Silver falling by 7% at one point before recovering to around 4% down at US $21.40 as I type this. However if we move to my subject of today there were also wild swings in the exchange rate of the Japanese Yen….

This week the exchange rate of the Yen has continued on quite a wild path as if we look at it versus the US Dollar it then rallied back above the 103 level only yesterday and this morning has dropped briefly (so far) below 101. We also have seen swings in Japanese Government Bonds with overall prices falling and yields rising and now the Nikkei has taken a plunge.

How will the real economy react to all this instability? Also how is the command economy experiment going? Watch this space….

This entry was posted in General Economics, Japan's Economic Situation, Quantitative Easing and Extraordinary Monetary Measures, The US Economy, US Treasuries, Yield and tagged , , , . Bookmark the permalink.
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  • Anonymous

    You have a lot in common with John Redwood – spot on analysis but nobody listens.

  • Andy Zarse

    Hi Shaun, whilst I too have grown weary of tedious homilies about democracy from the Higher-ups, I am completely fed up to the back teeth with central banks repeated attempts at market manipulation. Seriously, if anyone else tried such a course of action they’d be locked up, in theory at least.

    As you say, the results are a kind of avant guard white noise chaos characterised by wild and random fluctuations in asset prices. How is this fair on savers and investors, and how can their advisers make a assessment of markets when Govts keep sticking their flippin’ oars in? I can’t help thinking of the tale of The Sourcerer’s Apprentice, and the law of unintended consequences is going to play its mischievious role at some point very soon. Frankly, the sooner the brooms run out of control the better…

  • Drf

    I left a comment but it seems there are problems with the comment system again.

  • ernie

    Central banks only really exist to support their “client” banks and their governments. They have proved over and over again that they are unable to forecast economic trends/events and cannot actually change macro economic trends. They can, however, seriously distort short-term market price signals. In this crisis so far, they started by acting on interest rates, then moved on to becoming the receptacle for large volumes of bad assets via the various mechanisms employed such as QE. They have now moved to the final stage – outright buying of stocks in order to try and create some fantasy where higher stock prices will magically restore economic growth. The resulting distortions are obvious to everyone. The result is that the markets go up purely on central bank words/deeds and cannot sustain themselves on real-world data. The final outcome to all this is not in doubt. Perhaps if any of us is left standing after the tornado hits, we might consider abolishing central banks?

  • Anonymous

    Hi Drf

    Just to let you know I had raised the problems with the editor here and have forwarded this onto him so that he knows that the issue has not been fixed.

    Also apologies….

  • max

    very good post Shaun. I fear you are absolutely right, and since the central bankers have absolutely no idea what they are doing, it seems likely that QE to infinity will overshoot considerably.

  • Mike from Enfield

    An overshoot could, conceivably, be a price worth paying were it not for the fact that there appear to have been no measurable (positive) effects on the wider economy. As far as I know, unlike in the USA, the UK has no explicitly stated target at which QE is aimed – they just turn the tap on/off when it kind of ‘feels right’ (does the BoE employ astrologers…?).

    It seems most unlikely we’d ever hear an announcement that the policy is to be discontinued due to any negative effects so it will be interesting to find out which particular ‘beneficial’ effects they cite as having been achieved when (if?) it is ever withdrawn.

  • Anonymous

    So the broom runs out of control, does this result in currency collapse, social chaos and hunger ?

  • Noo 2 Economics

    Hi Shaun,

    I have to disagree with you and the markets on this. Bernanke was clear – “Unfortunately, withdrawing policy accommodation AT THIS JUNCTURE would be highly unlikely to produce such conditions” and then “IF we see continued improvement and we have confidence that that is
    going to be sustained, then we could in the next few meetings … take a
    step down in our pace of purchases.”

    The capitals are of course mine, so he says at the moment no way are we going to desist from ongoing QE but maybe, following continuous sustained improvement we COULD (not WILL) in the NEXT FEW MEETINGS i.e. at least 3 months away and maybe a lot further away than that reduce the purchase pace.

    What is there to misunderstand? It really isn’t his fault that markets have over – reacted to his comments even if there has been marginally disa[ppointing news from China which, at the end of the day is only 1 month’s numbers.

    I think the authorities (Governments, CB’s and IMF) are getting twitchy about how they are going to pull out of all this market interefrence, sorry, QE, without crashing every market in the World and it it was that fear that probably prompted the question that Bernanke answered in terms of demonstrating that he did have some kind of slow withdrawal plan

    Now, should CB’s be interfering with market pricing mechanisms whether that be equities or bond markets? Absoloutely not!

  • Anonymous

    i had that problem yesterday – took several attempts!

  • Anonymous

    Hi yarnesfromhorsham and welcome to my part of the blogosphere.

    Actually I have noticed that some of the messages and themes are hitting home but I am afraid that progress can be slow because our political class are resistant to new ideas.

  • Anonymous

    Hi Ernie

    Central banking in its current form certainly needs modifying in fact the entire banking system needs reform and change.

  • Anonymous

    Hi Max

    The only target the Bank of England has explicitly is the 2% inflation one. Maybe their failure there has put them off other ones! They are also supposed to “subject to that (inflation target), to support the Government’s economic objectives including those for growth and employment. ” But that is unquantifiable.

    More and more their argument for QE has involved the word counterfactual, or everything would have been worse otherwise which is weak at best.

  • Anonymous

    Hi Noo2

    The game goes on except as time passes there is more interference which will be harder to unwind. I always thought that “exit strategies” from QE type actions would be a problem and I think that more likely problems are appearing rather than less.