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Mr Bernanke’s pronouncement about the possible tapering of QE – call it a promise, call it a threat, according to taste – sent global financial markets in June into a spin. That is emblematic of the bizarre ways in which financial markets sometimes behave, for if tapering were indeed to begin in September or soon after, it would be a mostly positive development for anyone who still retains the capacity to think things through for the longer term. It would be ironic if fear of a negative market reaction was to jeapordise that outcome.
I am happy to concede that I am out of step with much published opinion on this subject. The majority view appears to be that the Fed has either simply got it wrong by prematurely announcing the demise of QE, or alternatively has badly mishandled its communications on this topic, scaring the markets unnecessarily and threatening another setback to the stuttering global economic recovery. Both views start from the assumption that a continuation of QE in the US is both desirable and will be a success, which sadly flies in the face of much of the cumulative evidence to date.
Judging by the comments of other Fed governors, as well as off-the-record briefings by unnamed officials, there is certainly something in the second point of view. It is one thing for central bank governors to embrace transparency in their pronouncements, but the efficacy of such an initiative is seriously undermined if the institution itself begins to resemble the Tower of Babel – too many voices, all speaking with a different emphasis, and significantly divided, as last week’s minutes of the open market committee showed, on what the core message really is.
Transmitting mixed messages is a clear breach of basic communication skills, as are clumsy after-the-event attempts to tell the markets that their initial reaction was mistaken.
I did not expect to see the day that serious investors began to say that they preferred it when the chairman of the central bank spoke gnomically, if at all, and nobody knew what the Fed was going to do next. Yet that, more or less, was the stance taken a couple of weeks ago by Jim Leaviss, head of the bond department at M&G, one of the UK’s biggest bond fund managers. He is right to the extent that the confusion over what exactly the Fed’s intentions are has if anything deepened rather than lightened since Mr Bernanke made his clarifying remarks.
But I am not sure that the market’s’response to the issue has been particularly coherent either. Many years ago, I recall Nils Taube telling me, as we listened to one of Gordon Brown’s early Budgets: “Remember the golden rule that the way the markets react in the two days before and after the Budget is almost invariably in inverse proportion to its quality” (and how right he was on that occasion). Much the same, I suspect, could be said about Fed-watching.
Not for the first time, observers have made some common mistakes in rushing to judgement on Mr Bernanke’s apparent change of tune. The first is taking their tone from the abrupt initial market reaction to the news, ignoring the fact that it came when equities and many fixed income securities had already become severely overbought, making a short term correction inevitable. To that extent the Fed chairman’s message was a convenient rather than a reasoned explanation for a correction that was already overdue.
Secondly, as many previous episodes, sudden corrections in financial markets often tell you less about changing fundamentals than they do about the positioning of the most highly geared market participants. The June sell-off in equities and other interest-rate sensitive assets was no different.
Thirdly, to the extent that the Fed’s apparent shift in policy is indeed a factor in recent market movements, it appears to reflect some over-simplistic analysis. Nobody who reads what Mr Bernanke said can honestly be in doubt about the meaning of what he has been saying. It did however alert many investors to the fact that their prior complacent expectations about the scale and timing of QE – and the likely path of the data which will drive the Fed’s decision – could be wrong.
Whether their current expectations are any more correct than they were before – and if so what that implies for future market direction – is another matter altogether. As the divisions amongst policymakers at both the Fed and the Bank of England make clear, timing the end of QE programmes, and doing so without harmful self-defeating consequences, is ultimately a matter of subjective judgment, not a simple binary decision that can be derived from objective analysis of data. Making those judgments was once what central banks were paid to do – and the more authoritative the leadership, the more effective (for better or worse) the result.
As it is, when one of the primary objectives of QE is to maintain asset prices at artifically high levels, central bankers who support it are discovering, just as many of us feared, that exiting the policy will be no easy matter, since by definition it leaves them dangerously in hock to investor expectations. Higher, less distorted bond yields at the long end of the curve need not be a disaster (it is hard to think of a more effective way to boost bank lending, for example, if that is your primary concern).
The real worry is that the current muddle and confusion may be signalling a process of gradual surrender by central banks, to both markets and governments, of their credibility and independence. For that reason if the economic data obliges this autumn, it is to be hoped that the Mr Bernanke can stiffen the resolve of his colleagues to stand firm in their resolve. If not, it will be another way station towards the ultimate end result of higher inflation.
Jonathan Davis 