“Even though further cuts are not justified by traditional economic metrics, the Fed will have no choice but to reduce rates. The markets are holding them hostage right now,” said El-Erian, the former co-chief investment officer at Pimco, the bond house. - from fnlondon.com
This is a poor choice for an analogy, but perhaps the logic for central banks should be reversed. The decade of QE was a market kidnap by the Fed to manipulate growth. The engineering of negative rates by the ECB was another financial market kidnapping. The huge balance sheet expansion by the BOJ was still anther kidnapping. Large foreign currency reserves held by other central banks are resources to help with market kidnapping. Forward guidance is just the threat of market kidnapping by central bankers.
I am always moved by Hayek's comments on the wisdom of prices for communicating knowledge as a first principle of economics. This knowledge and wisdom cannot be imparted when prices are manipulated in order to engineer an economy. Manipulation may result in unintended consequences as investors respond to these non-market prices. A market is held hostage when prices move against the will of those making economic decisions for investment and consumption. When economic agents driven by their interests move prices, it is not manipulation.
We are not arguing that Fed should be passive. Rates changes are a tool to support the Fed's dual objectives of stable prices and growth. However, rates cannot be used to subvert the natural behavior of business and credit cycles. Rate manipulation distorts price discovery and the behavior of market participants.
Rational expectations tell us that market participants will anticipate central bank actions and adapt. When investors are anticipating further central bank market manipulation, there are not holding the Fed hostage but acting on past Fed signals. This is an ironic role reversal.
I am always moved by Hayek's comments on the wisdom of prices for communicating knowledge as a first principle of economics. This knowledge and wisdom cannot be imparted when prices are manipulated in order to engineer an economy. Manipulation may result in unintended consequences as investors respond to these non-market prices. A market is held hostage when prices move against the will of those making economic decisions for investment and consumption. When economic agents driven by their interests move prices, it is not manipulation.
We are not arguing that Fed should be passive. Rates changes are a tool to support the Fed's dual objectives of stable prices and growth. However, rates cannot be used to subvert the natural behavior of business and credit cycles. Rate manipulation distorts price discovery and the behavior of market participants.
Rational expectations tell us that market participants will anticipate central bank actions and adapt. When investors are anticipating further central bank market manipulation, there are not holding the Fed hostage but acting on past Fed signals. This is an ironic role reversal.
How much is too much rate manipulation? Hard to say since the Fed kidnapper will argue that it was done for the good of the hostage. The Fed will argue the counterfactual that economic life would have been worse if its policies were not implemented. We are close to hearing, "I am manipulating prices for your own good.", or "I don't want to lower rates but you are making me do it".
There needs to be a middle ground for supporting growth but not distorting the allocation of resources in the real economy through suppressing yields to create unwarranted growth with excessive credit expansion. After months of forward guidance that rates should be lower and allowing markets to anticipate multiple rate declines, is it surprising that markets have gotten ahead of the Fed?
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