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2016-04-12 05:05:07
Mar 30th 2016, 16:18 by Buttonwood
TIME for equity investors to send Janet Yellen some champagne, or at least a
bunch of flowers. Once again, markets are rising because of something that a
central banker said. In a speech yesterday, Ms Yellen highlighted the complex
relationship between central banks and markets. Recall that the Fed raised
rates in December. Ms Yellen first notes that
The proviso that policy will evolve as needed is especially pertinent today in
light of global economic and financial developments since December, which at
times have included significant changes in oil prices, interest rates, and
stock values.
Those market declines don't mean that the Fed has altered its outlook for
economic growth and inflation. But they were still important because, she adds
investors responded to those developments by marking down their expectations
for the future path of the federal funds rate, thereby putting downward
pressure on longer-term interest rates and cushioning the adverse effects on
economic activity
In other words, the markets anticipated that, because they themselves were
falling, the Fed would not tighten as quickly as before. So the Fed didn't
actually need to act to stabilise the economy; market anticipation of Fed
action did the trick. As in Keynes's famous beauty contest analogy, we have
reached the higher levels of reasoning. Of course, this process still needed
the Fed to play along with market reasoning and it is. On the pace of rate
rises, Ms Yellen said
Reflecting global economic and financial developments since December, however,
the pace of rate increases is now expected to be somewhat slower. For example,
the median of FOMC participants' projections for the federal funds rate is now
only 0.9 percent for the end of 2016 and 1.9 percent for the end of 2017, both
1/2 percentage point below the December medians.
This relationship between the Fed's actions and market returns dates back well
before Ms Yellen's tenure. GMO, a fund management company, recently published a
paper looking at market movements on the day of Fed meetings. The Fed only
meets eight times a year. But since 1984, the returns on the days of Fed
meetings have provided a quarter of all returns. Take those returns away and US
equities would look reasonably priced under Robert Shiller's
cyclically-adjusted price-earnings ratio methodology. Indeed, in the depths of
the crisis, the market would probably have fallen back to a single-digit p/e.
The Fed prevented the market from reverting to the mean.
Here is the difficulty. Studies suggest central bank support for asset prices,
via quantitative easing, has increased inequality in both America and Britain.
But the central banks would argue that this was a price worth paying in staving
off the much greater threat of an economic collapse.
But this policy of intervening when markets wobble, dating all the way back to
the 1980s, has a steadily higher price. Over time, rates get lower and lower
and valuations tend higher. Debtors get used to ultra-low interest rates and
keep borrowing (that's the point of the policy, after all). But this means that
the potential cost of a reversion to "normal" levels of interest rates gets
even greater; imagine what would happen to homeowners if mortgage rates were
6-7%. What would happen to confidence if the Shiller p/e fell from its current
25.6 to the historic average of 16.7?
Central banks don't want that to happen and investors know that central banks
don't want it to happen. So the two are locked together like a barman and his
most profitable customer, endlessly pouring one more drink to fend off the
hangover and trying to forget about the cirrhosis that might set in. This is
not a new problem, of course; your blogger was worrying about it six years ago.
But we don't seem to be any nearer solving it.