Tuesday, May 20, 2014
Discussion; Volatility and Central Bank Influence
Extensive attention paid lately to the low level of volatility in rates, equity and foreign exchange. Historically, we have viewed low volatility as sign of extensive complacency or potentially unwarranted confidence that the future is knowable. Increasingly however, the low level of volatility is being attributed to Central Bank intervention with growing concern that the fall-out from an unrealistic sense of complacency will be very costly and damaging.
Knowing when to wane the child from his mothers breast is difficult, but few infants in the developed world perish in the transition. Economic agents have been encouraged to gorge at the overdeveloped Central Bank breast for years. I had written extensively in 2005-2007 about the danger involved with the Fed providing too much guidance during a period of ‘restrictive’ monetary policy and believe the transparency provided then facilitated mal-investment, a substantial contributor to the financial crisis.
Today, there is growing argument that the level of transparency or guidance provided by Central Banks (the Fed in particular) is excessive and contributes to a disconnect with the realities of risk. It is difficult for me to conclude as much outright as the level of economic activity appears to remain well below capacity. However, I am concerned that the level of Central Bank ‘intervention’ can have a debilitating impact on ‘animal spirits’.
We might have a higher level of confidence that diminished Central Bank guidance would prove attractive if in the face of above trend growth. I pray we will soon find growth at such levels so as to prompt at least strong consideration for reduced guidance. Reduced Central Bank guidance alone might prove a springboard for the outbreak of animal spirits.
The ‘policy-path’ implementation of tapering securities purchases, foretold in my December FOMC Report, has provided guidance in an unusual, yet no less significant manner. However, as the purchase program draws to an end, so does the ‘support’ provided by the know path of tapering (guidance). Unless the level of economic growth and projections for future growth are substantially stronger than at present, we should expect the Fed to provide alternative guidance.
Most would expect that guidance to come in the form of policy rate guidance, as in how long should the Fed be expected to refrain from lifting the policy rate, what length of time should be expected to elapse between the policy rate lift-off and reaching its equilibrium value and finally what is that terminal value.
The Fed may provide answers to all of the above, but we should not expect the Fed at this stage to limit itself to guidance concerned only with the policy rate. Given the changed nature of monetary policy implementation as a result of the large balance sheet, the Fed has an increased array of policy tools (IOER, Term Deposits, Reverse Repo) likely to provide opportunity for additional guidance and transparency. Even as the Fed is coming to terms with the value of these different tools, economic agents are anxious to learn how they will be implemented.
At some point, Central Banks will need to remove the ‘economic agent’ from its teat. However, as actual securities purchases are cut back and approach of policy rate lift-off continues, guidance will be increased rather than removed.
Comments from San Francisco Federal Reserve Bank President John Williams at yesterday’s monetary policy conference at the George W. Bush Presidential Center in Dallas, Texas made clear that the Fed recognizes the importance of predictability and guidance in the passages shared in excerpts from MNI’s Brai Odion-Esene note.
‘The FOMC has been scaling back its monthly bond purchases by $10 billion at each meeting since December, and Williams said the goal is to taper in a very stable and "very predictable" way so as not to spook markets, noting there has been very little volatility in the financial markets since the process began. This shows the Fed needs to "double down" on its communications and make it clear how it will act going forward, he said.’
However, others at the Fed seem less sanguine about the prospects for guidance. In an WSJ interview with Fed Rosengren; ‘Mr. Rosengren: We can't give more certainty than we know ourselves. It would be premature to lay out a fixed path until we have more information.’
The Fed cannot give what it does not have. This is why we differentiate between transparency and visibility. The Fed is able to provide transparency in what it expects it will do. However with lack of reference to for appropriate application of monetary policy under current conditions, the Fed is unable to proved actual visibility. Volatility levels are priced for perfect eagle-like vision and long-distance visibility.