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.
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.
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.
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….