When Mark Carney talks about the desirability of central banks having “flexibility” in providing guidance on monetary policy, what he’s really getting at is maintaining the capacity to surprise financial markets. Of all the tools in a central banker’s toolbox, the ability to shock – and thereby fundamentally change a game that’s going in the wrong direction – is perhaps the most powerful.
Unfortunately, it’s a tool on which the U.S. Federal Reserve Board is losing its grip.
Mr. Carney, the Bank of Canada boss, mused on policy guidance in a speech just one day before the Fed ramped up its own guidance to unprecedented heights in its rate-policy decision this week. Not only did the Fed institute economic-indicator “thresholds” at which it would consider beginning raising interest rates (specifically, an unemployment rate of 6.5 per cent and inflation expectations of 2.5 per cent), but it heaped on another layer of open-ended quantitative easing (the buying of longer-term government debt securities in the open market) to the tune of another $45-billion (U.S.) a month. The Fed now has $85-billion a month of QE and two economic hurdles to clear before it will raise rates; for market participants who like certainty on policy, that’s like a belt, suspenders – and a straitjacket.
While Mr. Carney has been a proponent, indeed a pioneer, in the use of more detailed central bank guidance to anchor market expectations in extraordinary times (and I’ve tended to agree with him), the questions that arise from the Fed’s new explicitness are whether these times are really so extraordinary any more – and if it’s doing more harm to the markets than good.
If the Fed’s main target with its heaping helpings of policy is the economy, the benefits have been questionable. Fed boss Ben Bernanke says it has worked. Legions of economists disagree. The initial institution of QE in 2009 did avert a 1930s-style depression, but subsequent rounds of QE have shown little influence in sparking a sustained recovery.
If reflating asset values in the financial markets was the goal, then there is evidence that QE may have been more successful. Capital Economics senior markets economist John Higgins noted that cyclically adjusted price-to-earnings valuations on the S&P 500 were about 14 when the first round of QE was instituted in 2009; now, they’re north of 21.
But at the current values, there’s little justification for the stimulus of QE – and, indeed, QE has shown a declining impact on stock values with each successive round. Nor is the policy showing the ability to have its sustained desired effect of reducing long-term interest rates. U.S. 10-year government bond yields are essentially unchanged from August, when it became clear that a third round of QE was imminent; in two days following this week’s increase of the QE program, yields were up nearly 10 basis points.
These markets know exactly what the Fed has committed to doing and they know that it has effectively tied its own hands for, literally, years. They also know that this represents a prolonging of policies that haven’t established a clear economic benefit; indeed, the Fed’s economic targets tied to the policy themselves signal that a sustained recovery is years away. It all ensures a one-way bet for investors – and the bet isn’t going the way the Fed wanted.
This is not really the relationship central banks want with markets. They would like the markets to be thinking for themselves – about economic prospects, about rates of return, about inflation expectations. Ideally, through their trading actions and the values they place on assets, the markets themselves help signal to the central banks a consensus of where policy should go.
And when the markets and the central banks are in fundamental disagreement, one that stubbornly impedes policy from having its desired effect, that’s when it’s handy for a central banker to have the element of surprise up his or her sleeve – to stun investors into adjusting their thinking.
It’s where we’re at now. But the Fed has nothing to hit the market with any more. Its ammunition is all in play, and splayed out across a multiyear landscape.
There’s a time for clarity of direction, when failing markets need to be put back on their feet. That time has passed. These are times when it would be more healthy for the markets if central banks kept a little something up their sleeves.