The grandeur of allegories is that they are able to transmit abstract concepts in a way that is not as vulnerable to manipulation and misrepresentation as words are. "The Boy Who Cried Wolf" (variously translated as "The Boy Who Lied", "Of the herd boy and the farmers" and "A boy and false alarms") is one of the oldest allegories of the Western World. In some versions of the story, the wolf eats the boy; in other versions, the wolf eats the sheep. But whoever it is that's on the plate, the drift of the story is short and sweet: There is no believing a liar, even when he speaks the truth.
Mario Draghi has come very close to being the modern personification of the boy who cried "wolf"; and as a result, the ECB president is being doubted, second-guessed and outright pilloried on the front page of every newspaper in the world in a way that no one would dare to apply to Big Ben. Three days ago, the following story ran in the influential German newspaper, Der Spiegel:
ECB Head Offers to Defend Himself in Bundestag
Under the Humphrey-Hawkins Act of 1978, the Federal Reserve must submit a report on the economy to Congress by February 20 and July 20 of each year, but these are pedestrian affairs that no one watches or cares about outside of financial circles. With nearly half of the population throwing darts at Draghi's face in Biergartens all over Germany, Draghi's offer to defend himself to the Bundestag is akin to Daniel walking into the lion's den without the benefit of the angel.
Bernanke only has to tweak an adjective or a verb and the markets respond. Draghi has to offer himself up on a plate to be heard.
(click images to enlarge)
Fig 1. Mario Draghi Gives A Speech To The Bundestag
Pre-FOMC Drift Moves The Market
The most important part of the Fed's credibility lies not in what the Fed actually does, but in the market's anticipation of what it might do. According to the Fed itself (New York branch), without the "Pre-FOMC Announcement Drift" -- the uptick in the S&P in the 24 hours preceding FOMC announcements -- the S&P 500 would be at or below 600 points, compared to its current level over 1300.
Fig 2. Average cumulative returns on the S&P 500 stock market index over different three-day windows.
Fig. 3. Effect Of FOMC Announcement Drift On International Stock Market Indexes
It's not what the Fed does that props up equities -- it's the expectation of what the Fed will do that props up equities. If you want a head-fake to keep working for you in a basketball game, occasionally, you have to shoot the ball.
There was also a presumption that Bernanke privately agreed with his detractors that previous rounds of QE weren't effective. In fact, as the Fed chief made abundantly clear in his Jackson Hole speech, he doesn't agree with this interpretation at all:
While there is substantial evidence that the Federal Reserve's asset purchases have lowered longer-term yields and eased broader financial conditions, obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult, as the counterfactual -- how the economy would have performed in the absence of the Federal Reserve's actions -- cannot be directly observed.
Translation: Bernanke doesn't care if you have a chart or a model that demonstrates that QE doesn't work. He has substantial evidence that it does. The Fed chief is stating that counter-factual estimates and projects are the equivalent of trying to imagine how well that hometown girl (i.e., the economy) would have turned out if she hadn't gotten pregnant in high school and run off with Johnny-football-hero. If she'd stayed in school and went to University, she might have been run over by a drunk driver 50 yards from the door of her college dormitory. The Fed has no intention of imperiling its mandate by entertaining hypotheticals -- the world that exists is vexing enough.
No New Normal: Enter Krugmania
Ben Bernanke, as well as Goldman Sachs' Chief Economist Jan Hatzius, are convinced that this a cyclical downturn and not a structural problem.
I see little evidence of substantial structural change in recent years. Following every previous U.S. recession since World War II, the unemployment rate has returned close to its pre-recession level.
In an environment where the actual unemployment rate is not coming down, at least not quickly, I think there's still room for monetary policy to do more.
The prevailing view at the Fed is that the problem is a lack of demand, not the increase in government debt or inflation. With QE3-to-infinity, the Fed has essentially adopted Krugmania: a more tolerant attitude by the central bank toward inflation, assuming a commitment to debt reduction in the long term. According to Paul Krugman, who was hired by Ben Bernanke at Princeton:
The attackers want the Fed to slam on the brakes when it should be stepping on the gas; they want the Fed to choke off recovery when it should be doing much more to accelerate recovery. Fundamentally, the right wants the Fed to obsess over inflation, when the truth is that we'd be better off if the Fed paid less attention to inflation and more attention to unemployment. Indeed, a bit more inflation would be a good thing, not a bad thing.
Why would a bit more inflation -- say, 4% -- be a good thing?
For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang -- by eroding the real value of that debt -- and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment -- again, helping to promote overall recovery.
This isn't similar to the Fed's argument for QE3-to-infinity -- it is the Fed's argument.
The Neo-Keynesian worm has turned, and is packing an Uzi. The following stocks are some of the top outperformers over the two weeks before and six weeks after each of the five previous QE-related announcements (QE+ Twist), and have also received a bounce following the Fed's recent announcement: SanDisk (SNDK), Schnitzer Steel Industries (SCHN), Nuance Communications (NUAN), Convergys (CVG) and Home Depot (HD). The average increase is about +20% pre/post QE.