How Not To Run A Central Bank

by: John M. Mason

Think back… what are the two news items that have taken up a considerable amount of space in the newspapers, on the TV, or elsewhere in the journalistic space since March 2013? First, is the Fed going to "taper" its purchases or not? Second, is Larry Summers going to be nominated to replace Ben Bernanke or is Janet Yellen going to be the one?

Central banking is supposed to stay OUT of the news! Central bankers are doing their job best when no one notices what they are doing. At least, that was the way it was once upon a time.

What about "forward guidance"? Forward guidance is all about the central bank telling the market what it is going to do for an extended period of time so that market expectations can be influenced and the central bank can achieve what it believes it needs to achieve in order to bring around the economic environment that is best for the country.

Forward guidance is all about influencing expectations. But, forward guidance is all about keeping the central bank IN the news! Forward guidance is what is causing all the volatility occurring in financial markets right now.

Is the Federal Reserve going to "taper" or not? That is the question. One day the Fed is going to "taper" and the next day it is not going to "taper." And on one day bond prices fall… and on the next day, bond prices rise.

This has led me to refer to this volatility as a result of "central bank risk." Let's face it… the Federal Reserve is not a real great forecaster of the economic future. The Federal Reserve is made up of humans and, for the most part, humans do not do the greatest job of forecasting the future.

We now have Alan Greenspan to deal with again in his newly published book "The Map and the Territory: Risk, Human Nature, and the Future of Forecasting." What I have read so far in the book leads me to believe that Greenspan thinks that the Fed's ability to forecast "sucks".

His reasoning, highly sophisticated and mathematically orientated econometric models are not able to incorporate "animal spirits." In other words, our economic models are not able to forecast the formation of market expectations and changes in market expectations. Our formal econometric models also do not have very sophisticated financial sectors.

Just mentioning these two factors leads one to conclude that forecasting using models like these are going to fall far short of being very accurate… especially at turning points. But, they are also weak in picking up structural changes in the economy that have major impacts over the longer run.

So, the central bank, the Federal Reserve… and the Bank of England… and the European Central Bank… expects us to believe that their forecasts will be accurate and that the policy directives they act upon will produce the results that they desire?

To me "forward guidance" is an act of desperation… nothing more. The Federal Reserve is trying to justify to the world what it is doing.

And, this effort is going to create expectations… expectations that will be disappointed… and expectations that will change… and expectations that there will be substantially more volatility in financial markets.

The economy works its way over time and what the central bank should try to create less volatility in the marketplace… rather than more volatility.

This is why Milton Friedman and John Taylor have emphasized "rule-based" monetary policy. But, that is obviously out of style.

What does the "discretionary" monetary policy not in effect do? In an effort to obtain desirable outcomes, officials at the Federal Reserve aim at things that they ultimately cannot control… like real economic growth and like unemployment. In attempting to achieve these things the Fed creates incentives that result in housing speculation and other speculative ventures (see "Blackstone Hits a Home Run" and "Shadow Banking in the Headlines: the Future is Here").

The fifty-year history of credit inflation brought us to the brink of the financial collapse in 2007 and the Great Recession. The quantitative easing of the last five years is creating even more distortions in the economy and who knows what volatility and turmoil is going to result from the efforts of the Fed to, not only "taper" its purchases of securities every month but to actually remove all the excess reserves it has pumped into the financial system.

To me, this is not the way to run a central bank. What confirms this to me is the fact that one policy directive, the one that resulted in the credit inflation of the past fifty years, led to a situation in which there were no good choices that the Fed could make. We got a financial collapse and a situation in which the Fed had to throw everything it could at the market to keep it from collapsing even more. Now, we are in another decision in which we have reached a point where there are no good choices available to get us out of the situation we are in.

Good policy should not leave you in situations where there are no good choices. Unfortunately, that is where we are today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.