The ascent of alternatives - endowments lead the charge

A big talk in asset allocation has been the search for yield, but it is just as important to remember there has been a search for diversification. These two key searches intersect with allocations to alternatives. Smart investors, endowments, have been actively putting their money to use with alternatives. A recent survey shows the allocation to alternatives by universities is now over 50%. Fixed income has been cut out of the portfolio and sits at 10%. The search for yields has led away from traditional bond allocations. Total equity between domestic and international is at 28%, but a large portion of the alternatives exposure is likely to be long/short equity strategies. 

Endowments have abandoned the 60/40 stock/bond mix and focused on strategies that give higher returns than bonds, similar volatility, and low correlation to core equities. Bonds have been a low correlated asset to stocks but the benefit is reduced when yields are low. Alternative strategies have volatility levels closer to bonds with a further diversification and return kicker. 

The market has responded to this demand with a significant increase in liquid alternative offering for every sized client. The issue is not whether you have alternatives in your portfolio but how much exposure. 

A difference in 2% for inflation - the world of difference

If we have 2% inflation, central bankers around the world believe the world will be a good place.  Economic growth, in their view, should be at or above trend. Inflation targets will be met and even if purchasing power is eroded each year, consumers and investors should be happy with "optimal" price increases. 

If we have 0% inflation, a 2% decline, there is the belief that economic growth will stall and we will be in a potential economic emergency. If we have 2% deflation, it seems central bankers think the world will be coming to an end. The world will be in a crisis which would require immediate action and the coordination of economic leaders. An increase above 2% would hardly cause much panic by central bankers. 

The non-linear response to declining inflation below 2% seems extraordinary. Inflation approaching zero and potentially going negative has a grip on the thought process of all policy-makers. A fear of deflation or zero inflation is justified, but are consumers and investors as sensitive to a 2% decline below target as central bankers? What is the sensitivity to money illusion? Are there a set of (non-monetary) policies that can offset the fear of living below the 2% target? 

Our thinking about inflation at 2%, 0%, and -2% levels has be better refined and clarified if we are going to survive the next few years. The fear of 2% below the inflation target has to be replaced with actions that can reduce market uncertainty and foster growth and productivity.

International credit channel - the Fed matters

The action of the Fed to increase rates cannot be thought of in isolation. The dollar is the key funding currency for cross-border credit. Any action to raise rates will have spill-over effects to the rest of the world. The US will export its policies to the rest of the world.

The international credit channel is critical for global growth and asset performance Investors need to think about the implications of any US action on the cost and availability of credit. Helene Rey gave the recent Mundell-Fleming Lecture at the IMF and presented research on how the global credit markets are connected. (The charts are from her presentation.) There is a global financial cycle which is affected by common factors. For example,  a shock to risk such as an increase in the VIX "fear index" will have a strong impact on cross border lending and pricing.

Rey also finds that the global credit is related to shocks in the Fed funds rate. If you just look at the size of dollar funding, this should not be surprising. A Fed funds shock will increase global risk premiums, have a negative impact on asset prices, increase volatility, decrease leverage, and cut global credit. The impact is across all markets and is sizable.

The Fed cannot think only about what is happening in the US when it take an action. Similarly, investors have to be prepared for a global fall-out from any Fed actions and the result may not be pretty.

Fed curb on bank commodity trading - good for CTA's?

The Fed is planning to move forward with rules to limit the trading of commodities by banks. The potential risks from trading commodities are thought to be great enough to require more capital or the risk of a potential taxpayer bailout, so Fed views a limit on bank commodity activity is warranted. It is not clear the specific form this will take, but it is likely that banks will be out of the physical commodity business and certainty will have a reduced presence in the trading of cash and derivatives. Serving as commodity merchant banks and dealers involved with storage and distribution may be a thing of the past.

An important source of trading capital will be gone from these markets which means risk and opportunities in commodity markets will change significantly.  At a high level, there will likely be a greater imbalance between hedges and speculators which means that time varying risk premia will be larger and more volatile. Banks will not be committing capital to provide liquidity and serve the needs of different market participants. 

This exit by banks will also led to a decline in liquidity or at least a transition in the liquidity providers in these markets. If less capital is committed, there will be an increase in liquidity risk premia. There is also be a potential break in the link between cash and futures. Banks have developed strong cash networks which have led to consistent activity in arbitrage between futures and cash markets. An important area of financial research has been the discussion on the limits to arbitrage. If financing and capital are not available to these markets, there will be more and persistent arbitrage opportunities. Of course, this just places markets in a state of flux. The exit of capital will increase profits for those who are willing to commit capital in the future. If profit margins are high enough substitute capital will be found; however, in the mean time, there is the potential for greater market dislocations.

For those who speculate in commodity markets, there can be an significant increase in trading opportunities in this new environment. Price shocks could become more extended so there could be larger trends in markets. This may especially be the case over short trading horizons. There may be greater deviations from fair value which will also offer more trading opportunities through arbitrage and spread trading. Alternatively, volatility in markets could increase such that there will be greater noise from short-term market dislocations. Finding trends and exploiting opportunities may be more difficult. 

The commodity market action will be more consistent with behavior before the ascent of bank trading. This new "old world" environment could be good for the traders who understand how to exploit hedging behavior and can provide liquidity.

The number one macro issue - liquidity

Markets will become more risky if there is less liquidity. As the rules of the game or market structure changes, there will be unintended consequences on liquidity and the market is moving to an environment that has less liquidity. Market liquidity is the ability of market to trade at fair value in size. It can be measured in the past, but we do not know the true extent of liquidity in the future until it is tested. 

There are some key structural features that will affect liquidity. Capital is needed to provide liquidity and make markets. If there is less capital committed to making markets, bid-ask spreads will increase. There will not be strong buyers when sellers come to market. Larger traders on one side of the market have to be matched by market participants on the other side. Market makers provide trading immediacy at fair prices. If bank capital committed to market making is reduced and there are no alternative forms of capital, liquidity will suffer. 

Diversity of opinion also is critical. Liquidity will not be provided if everyone is on one side of the market. The easiest way to get differences of opinion is through having more firms provide liquidity and trade the market. More firms trading lead to more opinions. 

Market uncertainty reduces liquidity and the move to electronic markets may foster more uncertainty. Traders cannot call around and gauge opinions of other market participants. If the rules of the game change, liquidity will become scarcer. Bid-ask spreads will increase if there is market uncertainty on why trading occurs. You will not trade with those who you believe have an information advantage.

Government regulators and central banks have been trying to make markets more resilient by changing the rules of the game. Policy has reduced leverage, changed financing options, reduced bank activity in non-lending business, reduced profitability from trading activity, cut proprietary trading, changed money market redemption terms and pricing, and reduced shadow banking activities. All of these changes have addressed key macro prudential issues in financial markets, but they also may made liquidity a scarcer resource. 

The BOE's Mark Carney is sounding a alarm in his "future of financial reform" speech. Liquidity is critical for functioning markets, but may have been given a priority in the post financial crisis environment.

ECB game on - inflation without delay

“It is essential to bring back inflation to target and without delay”, Mario Draghi, president of the ECB, said in a speech in Frankfurt on Friday.

This comment is the opening salvo for what will be the ultimate monetary battle between money suppliers and money demanders. 

In an effort to raise inflation rates, the ECB will do whatever it can on the supply-side. This means some further form of enhanced ECB quantitative easing. This will not be easy given the restrictions on what can be purchased by the central bank. They believe their job is to flood the market with money as much as possible to push inflation and inflationary expectations higher. 

However, the demand for money or more precisely the demand for credit is not present in the financial system. Money multipliers are down and excess reserves have been building. The demand for money is not strong. Put simply, the central bank wants to increase their balance sheet and force more money into the banking system under the hopes that at some point credit will be expanded and the money will be used to increase economy growth. This activity, in turn, should increase inflation. Another way to get credit and economic demand to increase is through changing inflationary expectations. If inflation expectations increase, consumers may increase aggregate demand today instead of delaying. The ECB objective is to bring inflation expectations back to target in order to get changes in consumption behavior.

Draghi's comments are not bold because the means of action are not clear, but it is game-on. Let's see if they can sway the market and money demand.

60/40 versus hedge funds - the asset allocation battle

There is big fundamental battle raging for the hearts and minds of investors, stay traditional through a core 60% stock / 40% bond portfolio or go alternative. Go cheap with traditional indices and diversify by asset class or pay more for the opportunity to diversify across more asset classes choices and through differences in style or strategy. It is a difference in diversification through the beta found in an asset class or diversification with alpha through strategy and skill.

The numbers suggest that liquid alternatives and hedge funds are making significant in roads in this battle although the long history of simple diversification provides a bastion of support for classic asset allocation behavior. Nevertheless, this is not a popularity contest of gathering assets under management. Historical numbers can be marshaled for both sides, but a more important issue is the underlying assumptions for asset allocation.

Here is the real battle. Should you diversify under the assumption that managers do not have skill and markets are efficient or should you hold a portfolio that accounts for skill and exploits inefficiencies and changing risk premia. Just when most investors have learned to accept the value of passive investing, there is a switch within the industry to active management through alternatives.  There is more complexity and nuance to this issue than what we have outlined, but some stark choices help frame the issue of how to structure a portfolio.

Given low bond yields, holding fixed income as a safe asset class may not be a good assumption. Broadening the portfolio makes sense; however, we are more suspect of low correlation from other assets classes. The evidence tells us that when you need diversification most correlations increase significantly. The demand for diversification cannot be met. The alternative is to gain diversification not just from asset classes but from strategies. Strategy diversification may actually be more stable and unique than what we find across asset classes. However, for strategy diversification to work there needs to be a set of criteria met that includes skill, liquidity, uniqueness, and depth. The value of a strategy is by nature limited. Everyone cannot do it.

Framing the asset allocation decision as one between beta and alpha, class and strategy, or passive and active skill may not make choices easier but does focus the decision on what is important.

Deglobalization - the financial world is disconnecting

The world is getting more disconnected if you focus on global capital flows. Global capital flows outstrip movement in trade, so it is a strong signal of globalization. These flows are what moves savings around the world from creditors to debtors. The numbers are showing a sea change in financial behavior. Kristin Forbes of the BOE gave a good speech on "Financial Globalization" and the implications for global finance. It tells s tory of global financial world in transition.

Pre-financial crisis, the capital flow numbers were on track to represent almost half of GDP. The crisis changed the world with capital staying put or moving back to their  home countries. Banks especially retrenched their appetite for global lending. This change is really hitting emerging markets.

Some  of this flow slowdown is associated with slower global growth. The decline is also correlated with the fact that rates around the world are at similar levels. But, perhaps most important has been the anxiety about investment risks around the world. In spite of volatility in many markets being low, investor have returned to having a strong home bias. The retrenching for today may lead to more  global opportunities of tomorrow; however, right now, financial behavior is reflecting an inward focus and many global investment projects are suffering.

Chase hedge fund winners, but only so far

Momentum is everywhere and it is a strong foundation for any active management strategy, but there is an alternative view that chasing winners is a fool's game whereby buying of tops and bailing on losers will be a easy path to failure. The answer is somewhere between these extremes as presented by the Common Fund in their August 2014 white paper Chasing Winners: The Appeal and the Risk.

Their paper which evaluates hedge funds shows that chasing hedge fund winners, those with performance persistence, is a good thing except you do not want to chase too long. The longer you hold a winner, the more likely you will underperform.  Winners get stale. This is consistent with the research on momentum in stocks and in asset classes. In fact, you should do a quick evaluation, hold the winners for under a year and then move on. Active management of hedge fund winners makes a difference.  

Nevertheless, their work provides additional insight on skill based or alpha managers. Choosing those who are hot may make sense, but finding those with skill is even better. The winners or momentum strategy may be picking up trends in the underlying asset classes or beta while skills through alpha generation may transcend a trend. It is an interesting perspective which needs further exploration. Most likely, finding winners with skill is the best of both worlds but the rarest of managers.

Evolution of asset management - the march of indexing

A nice way to describe the evolution of the asset management industry is through the march of indexing. Returns can be broken into beta and alpha. The asset management industry has been able to form low cost indices for asset class beta. The replication of beta is not hard. 

It has now developed alternative beta approach to capture systematic risk premia.  This was creative but is now easy to replicate and produce for the masses. The next level of evolution has been to bundle multi-asset solutions which may be a cross between beta and alpha. Indices have been formed for these cross-ver products although this part of the industry is evolving. What has not been indexed has been manager skill which receives higher fees and should generate better return to risk. You cannot make generic products for manager skill.

The asset management industry is not that different than other industries where generic products are priced low and mass marketed, and customize products that require more skill to produce still receive premium pricing. If you cannot distinguish skill, you will be squeezed by the generic index products. The industry evolution now requires managers to better define and communicate their skills.

The "free lunch effect" - Don't be afraid of volatility

Salient Capital has written a very good white paper on the effects of diversification. Using simple concepts from modern portfolio theory, the authors describe what they call the "free lunch effect" and make a key distinction on how risk reduction occurs in a portfolio. There is nothing truly new here but the presentation nicely shows the two different channels of diversification and the important impact of their free lunch effect.

This effect is the gain from diversification through holding uncorrelated assets. When you add an asset to your portfolio, you actually effect volatility through two channels. One, there is a de-risking channel because volatilities are not the same. You can just reduce portfolio risk by adding assets which are less risky. That is easy. But, there is a significant cost because returns will also fall and at best be the weighted average of the returns between assets. De-risking diversification by itself, when the correlation between assets is one, does not improve information ratios. It is the second channel through differences in correlation that provides investors with a real benefit. As the correlation declines, the benefit of diversification increases. This is true diversification because you can lower risk for the portfolio by more than just the weighted average of asset volatility included in the portfolio. You receive a gain in the information ratio of the portfolio.

The table above shows the impact of adding bonds to an equity portfolio through the simple mix of a balance 60/40 blend. Since bonds have a lower volatility, you will get lower risk, but there is the added benefit from the fact that the two assets are not perfectly correlation. However, you can take a deeper view and see that most of the risk reduction comes from de-risking and not diversification. The lower return comes from just holding a less risky asset which had historical lower performance.

If it is low correlation that provides the most portfolio benefit and not de-risking, it makes sense to hold a risky asset with corresponding higher return that will provide more bang for the buck from its low correlation. It does not make sense to hold a low correlated low risk asset. The figure below shows the added free lunch effect from holding a risky asset which is uncorrelated. This solution is all driven by the simple formula for finding the volatility of two assets. All of the action is in the correlation between the two assets.

So if you want the free lunch effect, what assets should you buy? The results may surprise some. The key benefit comes from managed futures and commodities even though both are riskier assets as measured by volatility. The diversification benefit from alternative investments does not come from long/short equities but from the strategies that are fundamentally different. Investors should not be afraid of volatility if the there is more benefit from lower correlation.

Does the Fed need a third mandate?

The Fed has a dual mandate of managing inflation and domestic growth, but for the good of the global economy does it need a third mandate, an international liquidity mandate? 

As the reserve currency of the world, the policies of the Fed impact global liquidity. Regardless of the talk of alternative reserve currencies, the dollar is not going to be replaced in the near-term. There will be changes on the margin, but more Fed liquidity means more global liquidity and a cut in US liquidity will have an adverse impact on the rest of the world. 

When money flows to the US, it is flowing out of somewhere else. It does not matter if it based on a search for safe assets or better investment opportunities. With US rates higher than most G10 countries, money will flow to the US. If money flows are expected to tighten in the current post-QE period, funds will flow out of risky EM investments. We have seen this in both EM stock and bond markets.

If the Fed is truly interested in macro prudential policies, then it should start with its role as a global liquidity provider. This is not a new issue, but the view that EM economies would be independent Fed monetary cycles has proved to be wrong. "Benign neglect" of currencies implications by the Fed  is misguided. A benign neglect Treasury strategy misplaces where the power in currency determination exists. 

Liquid Alt diversification wrong

Yet many of the financial advisors who use them are “doing it all wrong,” said Nadia Papagiannis, the Director of Alternative Investment Strategy with Goldman Sachs Asset Management, which has made a big push into liquid alternative funds. “Every survey out there shows advisors want liquid alternatives for diversification.” Yet most of the money is going into a single type of strategy: long-short equity, which seeks to provide some cushion to falling markets by shorting a select group of stocks alongside a traditional portfolio.

from Wealthmanagement.com http://wealthmanagement.com/impact-2014/drowning-liquid-alts

This is a very important observation that needs to be addressed by all financial advisors. It does not make sense to diversify through just buying long/short equity managers which reduces your stock beta. It would be cheaper and more efficient to just cut the beta in your portfolio. If you pick long/short managers, it should only be done when you can get alpha cheap not less beta.

The better strategy is to hold true diversifying strategies like managed futures. Now managed futures is not always the solution. The key is trading many markets across many asset classes so you can get changing exposures beyond stocks and bonds.

Stagnation problem in one chart

This single chart of actual versus potential GDP tells the story for why voters and consumers are not happy with the economy. They may not be able to put it into words, but this is the aggregate demand issue.

Closing this one-time gap is what monetary and fiscal policy wants to do. It has not worked, or more precisely it has not caused the current trend to be draw closer to the potential trend.  A close look at the data suggests that the trend is on the right path, but there has been a one time loss between the middle of 2008 and 2009. The economy has not been able to shake that loss. This loss could be the leverage problem of excessive credit expansion that will not be solved under a more regulated and controlled environment.

Japanese forward guidance clarity

BOJ Governor Haruhiko Kuroda, said "There's no change to our policy of trying to achieve 2 percent inflation at the earliest date possible, with a roughly two-year time horizon in mind ... There are no limits to our policy tools, including purchases of Japanese government bonds ... In order to completely overcome the chronic disease of deflation, you need to take all your medicine. Half-baked medical treatment will only worsen the symptoms." Kuroda added, "The benefits of a weak yen outweigh the costs if the yen's declines reflect economic fundamentals."

These quotes are extracted from BNY Mellon. It does investors in very clear language what the BOJ is trying to do, how long it may take, what means will be used, and the fact that the process will not be done half-heartedly. Given how Japanese officials can be less than perfectly clear . This is as good as can be expected forward guidance.   

We are near the Fed's monetary policy bulls-eye

Nice single chart on what is happening between the trade-off of inflation and unemployment. The answer is not much from the folks at economonitor. There has been no trade-off. In fact, you could say that we are near the bulls-eye of the dual policy goals of the Fed, yet there is little talk of success. How close to do we have to be to get the Fed to raise rates? It is not clear and that is the problem.

QE-lite - the reinvestment issue

The Fed is not buying up any new debt with the end of QE3, so the balance sheet of the Fed will not be expanding, but there is an ongoing QE-lite policy. The proceeds from maturing bonds will be reinvested in new bonds which means that time will not reduce the Fed balance sheet. This is a bond ladder that will not go away 

In fact, through the portfolio balance effect, the Fed may still have an important impact on the yield curve through its purchases. It will have cash from bonds that mature and this cash could be invested out the curve to affect its shape. The "Twist" component of Fed policy will still exist even if rates start to rise on the front-end of the curve. 

QE-lite will be a new gift or tool of the Fed which creates new bond market uncertainty. 

Innocent "currency war"?

Can you have an innocent or unintended currency war? Or, is any policy that causes FX rates to decline another belligerent act in  the current ongoing currency war? 

The BOJ has just increased its QE program to increase the money supply. The impact will be a lower Yen. We saw the market response immediately. The BOJ wants tin increase domestic inflation which will increase domestic spending. It will also make exports cheaper and imports more expensive. The BOJ is exporting its disinflation to the rest of the world. Is this an act of war with the rest of the world or just a by-product of their efforts to solve domestic problems. No one will outright admit to the exporting of deflation, but that is the result.

The question is whether this action from Japan is good for the rest of the world. Regardless of whether the intention is benign, the impact is downward pressure on prices in the rest of the world.  This is the current state of the post Bretton Woods environment of uncoordinated policies.

"Save our Swiss Gold" referendum

Now this is an example of real economic policy put in practice through the votes. At the end of this month, the Swiss will have a "Save Our Swiss Gold" referendum to determine whether the Swiss central bank will be required to hold a fixed percentage of gold to back reserves. The Swiss monetary reserves, about $550 billion, would have to be backed by 20% in gold. It now holds about 7.7% in gold, so there would have to be a massive buying program to bring back gold into Switzerland or a significant cut in reserves. 

This new policy would do the exact opposite of  what the SNB has been trying to do with its money supply and currency.The central bank has been attempting to reduce the upward march of the the Swiss franc which has hurt the Swiss export business. Right now the Swiss franc is working under a floor of 1.20 euros, so the exchange rate has not been very volatile given the constraint has been binding. This floor has caused significant selling of francs.

This passage of this vote is real and has not been the focus of the market. We will all hear more about gold, money and exchange rates in the next four weeks. 

Disinflation is real and global

Looking just at G10 countries tells an interesting disinflation story. 9/10 countries are below their inflation targets. 9/10 have QOQ inflation numbers falling. Inflation is moving away from targets and not  toward the targets. This sample is biased by Europe but the number are clearly in one direction. Disinflation is a global phenomena. This makes for a bond market that can continue to rise. Firms will have limited pricing power so profits should fall and revenues decline based on delayed spending. It is unlikely that the Fed will raise rates in this environment. It requires more not less action by the ECB. 

Summers critique of government debt and monetary policy

The latest buzz in macroeconomics is what I will call the Summers Critique of Debt and Monetary Policy. It can be found in Government Debt Management at the Zero Lower Bound from the Huchin Center at Brookings. The argument by Summers and his co-authors is simple. The Treasury has been issuing more debt and have extended its average maturity in order to take advantage of the low interest rates in the debt markets. Finance government at long-term at low rates. Of course, this new supply could force up interest rates. This is up for debate but depending on your view of yield curve and flow of fund dynamics. The Fed at the same time has been buying up long maturity debt in order to push down rates. The action of the Treasury could actually be offsetting some the work that has been done by the Fed to bring down long rates. It is an empirical question but there is a chance they are working at cross purposes.

The Treasury debate increase on the long end of the curve is about 70% from debt increases and 30% from lengthening outstanding debt. The Treasury has been managing debt without thinking about monetary policy and the Fed has been thinking about managing long rates without accounting for  debt management activity. Their independence is placing debt and monetary policies at odds.  These choices place the economy at risk because there is duration risk with financing options.

The Summers argument is that the Treasury should be financing with short rates where rates are zero instead of putting upward pressure on long rates. There may be a shortage of  the safe asset so borrow at the lowest financing costs now and worry about the future tomorrow. While the offset has not been one for one, the authors believe that the Treasury debt management has been a drag on Fed effectiveness. This management issue may become all the more important with the end of QE. The unwinding should be coordinated with the Treasury department.

Diminishing marginal efficiency of monetary policy

Monetary policy is not different than any other good or service. There is a law of diminishing marginal utility or efficiency. As more money through reserves is pushed into the economy, the marginal impact of that dollar declines.

The first QE period had a significant economic effect because a lot of liquidity was needed immediately. Each subsequent QE has had less impact on markets, albeit the equity markets do not seem to follow this rule. Excess reserves have increased because the amount of lending relative to total reserves is less. Banks do not know what to do with the excess relative to the amount of effective loan projects available. The money multiplier has remained low.  This has led to a lower chance of inflation. There is still a zero bound problem, but there is also a simpler problem that extra money is not needed to increase aggregate demand Put differently in simple microeconomic terms, any marginal increase in money will have limited impact. 

This is a good reason for halting QE in the US; however, it also means that other policy initiatives will have to be employed if monetary policy is to be effective. This is one of the reason for the emphasis on forward guidance and the desire by the Fed to control expectations. Pushing more supply may not be effective. 

Prices or fundamentals - the trend provides a tailwind

The reason why I use trend-following as core strategy is simple. I believe that prices and trends tell me something about the macro economy in a way that looking at fundamental data about the economy do not.  I review fundamentals, but there is a lot of noise in this data. There is noise in prices, but prices are primal to determining return. There is no ambiguity about what the data are saying when I am long a market and prices are trending lower. This is price efficiency in a very real sense. The trend is efficiently telling me that I am wrong.

I read the newspapers and research but there often is no clear consensus on what the data are saying and how it should be interpreted. I listen to central bankers and cannot say there is a clear message that can always determine the direction in price. I hear the stories about a market, say oil, and cannot determine whether the price decline is driven by declining demand or increasing supply. It is hard to weight these alternatives. Knowing and understanding market behavior is critical, but money management is often about engineering and getting the performance problem right.

I do currently know that the consensus of buying power is for higher equity prices. I look at the trend. I do know that oil prices are out of equilibrium because prices are trending lower. Price trends have lower ambiguity than data because data are one step removed from return generation. Fundamentals and risk factors change and may tell me something about what may happen in the future, but if I follow a base case that trends will continue, I will likely have a performance tailwind to help.  

Deflation fears and central bank creditability

The post-80's period of central banking was all about creating creditability as inflation fighters and breaking inflation expectations. Central banks were only able to tame inflation when they were able to convince investors that they they could control inflation at set targets. The wave of inflation targeting and central bank transparency was all an effort to increase creditability. Central banks were successful at changing expectations and inflation was maintained close to target levels. It was expected that higher inflation would be met by tighter policies and targets would be maintained. Even the Fed which has a dual mandate was able to increase their creditability substantially as inflation fighters. The taming of expectations was won. 

Central banks may have done too good a job. Now central banks want to be known as deflation fighters who can raise inflation and hit targets from below. This adjustment in their creditability to inflation creators has been slow. Inflation expectations over the long-run have been close to targets but there has been a wariness that central banks do not have the tools or resolve to rid economies of deflation fears. The forward guidance has been ambiguous concurring their resolve to get inflation higher by the Fed. The resolve is also being questioned in Europe regardless of comments by the ECB president.

Perhaps the announcement by the BOJ to following QE will do the trick. The market reaction on Friday seems to be tiled to the belief that the BOJ has turned the corner and is willing to go to extraordinary length to get inflation higher.