The point of central banks

January 25, 2016

Much of the analysis of the recent market turmoil is amusing.

Take the Wall Street Journal, Why the Fed Is the Root of Much Market Turmoil: Fed is a key reason markets have plunged and risk of recession rising .

Here is a quote:

Now, after several bone-jarring weeks to start 2016, many investors hope the Fed is having second thoughts about raising rates three or four more times this year. The newfound attention on the January meeting illustrates something few people, even at the central bank, truly appreciate: The Fed is a key reason markets have plunged and the risk of recession, though low, is rising.

It can't be all investors, in the same issue of the Journal we had this piece Automated Hedge Funds Make Millions in January’s Market Selloff: Tumbling oil prices, decline in global stocks provide near-ideal conditions for computer-driven funds.

The implication of this is that `many investors' would think that the central bank not only has it in its power to control the markets and economy, but also outright its duty to do so. One might have thought that the recent experience from China pointed to the limitations of the central banks to do exactly that, not even with the entire apparatus of the state behind it.

The conclusion of the piece brings it it to earth:

None of this means the Fed was wrong to pursue such aggressive monetary policy. Getting unemployment down to 5% is a reward almost certainly well worth the associated financial risks. Yet it underscores the dilemma that will dog the Fed for the foreseeable future. When the “neutral” interest rate, which keeps the economy at full employment, is so low, the Fed will find that boosting growth invariably fuels financial excess. “It’s no longer neutral because it’s not consistent with long-term stability,” says Mr. Berezin of BCA Research. “You end up with this possibility that there is no neutral rate at all. So what then is a central bank to do? There’s nothing it can do.”

I like that last point, "So what then is a central bank to do? There’s nothing it can do." The only question is, why would anyone think otherwise.

By relying on central banks to be just about the only government tool to help the economy, and expecting it to help the markets, in some cases by becoming the liquidity provider of first last and only resort, we have created that dangerous dependence on liquidity. The expectation is that the liquidity somehow trickles down to the SMEs while blowing asset bubbles and increasing inequality along the way. Perhaps it's no surprise that `many investors' don't like interest rate raises.

The problem is not raising interest rates now, the problem has been relying too much on liquidity in the past. By continuing to abuse the central banks in his way, building expectations that cannot be realized, we just kick the can down the road, making yet more market turmoil inevitable.

---

---