Have Central Bankers Become Helicopter Parents?

by: Chris Mier

Summary

Central bankers across Europe are finding new reasons to stay enmeshed in financial markets when prudent central banking orthodoxy might suggest otherwise.

In the post-Lehman era, central bankers are inclined to believe that each potential crisis requires a new solution, which carries with it its own new set of risks and requires.

In short, the doctor is committed to over-medicating the patient.

Central bankers will frequently pay homage to the notion that good central banking requires self-imposed limits that confine their activities to their legal mandate. Frequently, though, the reality falls short of the ideal. Just as no pilot wants to get behind the wheel of a brand new jet only to have the autopilot feature take control, the Fed continues to find reasons to stay involved rather than to let go and trust markets to set prices.

In 1977 Congress dictated that the Fed pursue the twin goals of maximum employment and price stability (and "moderate long-term interest rates"). While Fed activities are described in law, there is substantial flexibility allowed for how that mandate is approached. The law does not place limits, for example, on the Fed's use of a wide variety of monetary tools; like quantitative easing, forward guidance, reverse repurchase agreements, and others; nor does it describe a philosophy or an approach. Currently, a directive in the law requiring the Fed to limit its involvement narrowly to activities only in direct pursuit of maximum employment and price stability would be useful in providing limits on Fed hegemony. The flexibility afforded in the language of the law allows for an expansionist mindset that allows new objectives to creep into the stated mandates. It's what you might call "Fed-creep".

An issue generating a lot of central banker concern right now is "financial stability concerns". Having just experienced a visceral demonstration of the speed and power with which collapsing financial markets can adversely impact the real economy, central bankers are focusing on monetary policies to exert greater control over financial markets. In a speech before a Deutsche Bundesbank Conference entitled "Financial Stability and Monetary Policy: Happy Marriage or Untenable Union?", San Francisco Federal Reserve Bank President and CEO John Williams discussed this new frontier of angst, what some central banks are doing about it and the possible consequences.

Some central banks have officially embraced the idea of taking monetary policy actions to address the threat of a new financial market shock, which might once again crater the economy. While the desire to avoid repeating the performance of the financial crisis and the Great Recession is wholly appropriate, the consequences of the actions being taken to that end are not well understood as of yet however, and could prove quite costly in their own right.

Central banks that have sought to give focus to financial stability concerns have done so, as President Williams points out, at the possible expense of growth, higher unemployment, and the possible perpetuation of dangerous deflationary trends.

In Williams words "Particularly worrisome are the incipient signs that inflation expectations are slipping in countries that have emphasized financial stability in monetary policy deliberations". Norway and Sweden have both adopted this approach. In those two countries, falling inflation expectations risk protracted weakness in aggregate demand, promoting a potentially dangerous cycle of sub-par growth and higher unemployment. It's hard to calculate the benefit of avoiding the economic disruption caused by the financial collapse that didn't happen, though, making a benefit cost evaluation impossible. One can't help wonder, though, if the benefit of focusing monetary policy on financial market stability concerns is worth the "clear and sizable potential risks", as Williams notes, or if we are dealing with a "Clear and Not-so-Present Danger", to paraphrase the movie title.

This question is particularly relevant now in the US, where employment has only now reached a level exceeding its pre-crisis peak after 5 full years of economic recovery and massive Fed accommodation. Focus on financial market stability is said to extract a price in terms of output and unemployment. With an ongoing discussion about possible secular stagnation, it is possible the central bank concerns about, and excessive focus on, financial market stability may be one of the contributing factors; along with income inequality, demographics, risk aversion, excess global liquidity, and other commonly cited culprits. While some of these possible factors are beyond the reach of a policy response-like our aging population--limiting central banking intervention is within our power, and worth considering.

Williams' speech touched on behavioral economics and its insights on asset pricing. Extrapolative expectations-the tendency for economic agents to believe that the "trend is their friend"-is seen as fertile ground for investigation into what causes elevated asset pricing. The Fed is unwittingly reinforcing the impact of these extrapolative expectations, however, by engaging in monetary policies that boost housing, bond and stock market prices higher rather than allowing market forces to be reengaged in setting market prices. That market participants can point to the Fed accurately as pulling the policy levers to boost asset prices lends rationality to extrapolative expectations.

The Fed is preparing markets for the potential problem of excess reserves, which could limit their effectiveness in raising short-term rates when a process of normalizing the fed funds rate begins. One proposed solution is for the Fed to actively engage in money markets via reverse repurchase agreements. This would enable the Fed to reduce excess reserves and offset the risk that the Fed would be constrained in their ability to increase short-term interest rates. It could require a substantial involvement in the money markets as a borrower of excess funds via the collateralized sale and repurchase of securities in their extensive treasure chest of financial assets. While this strategy would likely facilitate the process of maintaining market interest rates at levels appropriate to the targeted fed funds level, it also creates the rationalization by which the Fed remains enmeshed in financial markets with the left hand, just as the right hand is beginning to loosen its grip.

Under current conditions (conditions engineered by the Fed, of course), an overwhelming array of market-based information, supports what the St. Louis Fed Financial Stress Index and the Kansas City Financial Stress Index show: financial stress is not visible.

What is causing all the central bank angst? It is the withdrawal of the Fed from active bond buying and the contemplated movement of the nominal funds rate to higher levels that is eliciting these concerns about the incipient return of financial calamity. While concerns are certainly appropriate, not all concerns require responses, however. The lack of financial stress evident in financial markets at this juncture suggests that the Fed consider less rather than more market intervention.

The Fed should consider taking the training wheels off and allowing markets to respond. Freed of the grip of the Fed, we may find that conditions are sufficiently sanguine that financial markets can do what we trust them to do-allocate capital efficiently at prices determined by the buying and selling decisions of independent market participants. This would benefit the economy, by allocating capital more efficiently, and financial markets, by restoring appropriate penalty for risky behavior.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.