Tuesday, March 24, 2015

Yellen Isn't Yellin' Anymore

During times of liquidation, panic, and revulsion, when authorities are trying to establish a definitive floor under asset prices, and create an atmosphere of greater confidence in order to assuage fears and encourage longer-term capital investment, there is reasonable benefit clearly telegraphing policy intentions. Speculators may (and probably will) use this elevated level of certainty to front-run actual "real" flows. And this is fine and good since desired policy outcomes (at such times) tangibly benefit from the reduction and/or elimination of speculative short positions (or at the very least refraining from disinvestment or erstwhile liquidation). Policy objectives, are further hastened by speculative flows, at least initially, whether by confidence-bolstering or behavioral feedback effects.  While the promise of backstopping is real, the primary effect results from old-fashioned "jawboning" to harness otherwise pro-cyclical flows to stabilizing, counter-cycling effect. At such times, it likely that just credibly stating that one will pursue certain stated policy(s) with defined objectives is often more efficacious than the implementation of the policy itself - the operative word being "credibly".

There comes the point in the inevitably-cyclical process - recent context being QE2 or QE3 or the present (choose your poison) - where fear of the abyss has passed, and when prevailing policy's "certainty", is extrapolated and viewed as providing perennial and asymmetrical risk-reward, or a proverbial "free lunch", irrespective of the extraordinary conditions for which it was originally conjured, and its decidedly-temporary nature when seen in an historical context. This is the moral hazard that policy certainty can wreak in general, and what disturbs me about ZIRP/QE in particular. The macroeconomy, in its aggregate investment decisions, typically overshoots sufficiently well without the further help of leveraged, speculative flows. There is little to done about The People making overenthusiastic coincidental investment and consumption decisions on the basis of the recent past, outside the modulation of traditional fiscal and monetary policy. This IS the business cycle.

Given the size of the financial economy in general, the increasing size of trading-oriented, leveraged investments, and feedback-related trading and risk-management styles, and the general hordes within the momentum-driven electronic herd, much of which is focused upon, and driven-by observing rather arcane nuances in policy, central-bankers in particular should, rightfully, be mindful of aligning the aggregate animal spirits in the general economy with leveraged financial speculation attempting to game perceived policy certainty.  In short, in order to deter leveraged speculative activity at such times, when it is, as Rumsfeld might have termed, "decidedly unhelpful", i.e being pro-cyclical well-after the sell-by date of its usefulness, markets periodically NEED to be spanked. They NEED to understand that policy should, and will be, data-dependant. That might include whipsaw moves in rates and prevailing policies, even if sub-optimal with perfect hindsight. They [markets] need to understand there is no certainty, and no free lunch. And as more and more investment becomes rote, algorithmic, and systematic, these models (and their programmers), too must incorporate uncertainty at levels that incorporate longer-frame regimes than many systematic macro and risk-parity strategies contemplate or integrate, or other endeavors that overweight recent regimes at the expense of the more-distant-but-not-wholly-irrelevant past, or the next. Should one doubt the benefits of such an uncertainty principle,  simply imagine the wild rumpus that would ensue following universal pursuit of the free lunch. Some would argue we're already there (though I am not so stridently convinced despite sympathetic caution).  

Pulling away the milk-teat is never easy. Markets will need to get used to a return to policy uncertainty. There is significant momentum in the real economy, and it is likely it will not be derailed by a bias towards higher rates, or marginally-increased financial market volatility. We should not shed a tear for those Icarii who get run over by it's process.  I've no problem with the authorities acting as "Lender of Last Resort", or the idea of their provision of liquidity as systemic backstop. But precisely "where", and "at what cost" should remain ambiguous to prevent the cleverly rapacious psychopaths amongst us from [trying to] test their boundaries and aggressively game it. In this regard, the fact that Yellen isn't yelling [specific certain forward policy guidance] anymore is highly appropriate.  Get used to it. Embrace it. And remain mindful of charlatans with strategies overly-dependent upon mindless extrapolation and leverage.


Polemic said...

Completely agree Cassie, but I do think there is a catch this time.

Letting the equity market take a bloody nose a valuable learning experience in the playground of market life, but I feel that the market that needs the biggest punishment for complacency is, this time, the bond market. Now whilst the equity market is connected to state, though it is private, the bond market is linked to the state via a knotted rope around its neck. Punish the bond holders and as a government entity you might as well wire your balls to wet sponges connected to the mains and switch on!

Going to be a toughie!

Mercury said...

She wasn’t yelling but she may have been winking. The markets haven’t exactly reacted as if they are now allowing for greater uncertainty. Your conclusion seems to contradict your sound argument for the proper role of the Fed. Distance from the abyss as measured by officially important data doesn’t seem to be matching up with Fed actions. Fed mission-creep is a possibility here as is waning significance/accuracy of said, officially important data. Are we really supposed to take heart that the Fed has removed one adjective which probably means that at some point they might inch slightly further away from ZIRP? Not sure that even qualifies as showing a little ankle.

I’m surprised you didn’t mention Japan here. Exactly what is their anticipated ZIRP end-game…or is there acautionary tale to keep in mind here?

Renaud M said...

A masterpiece for the ignoranti like me

vlade said...

Cassie, absolutely agree. I was saying for quite a while that CBs should be silent 95% of the time (or close to silent), and very very clear and specific for the rest of the time.

Otherwise, you'll get what we've got.

vlade said...

But I'll also say add something else. If CB does say something clear, it should hold to it. Unlike SNB in January, which IMO was just idiotic (if one shoots himself into a foot, one should at least hope to gain something, unless he's a masochist)

braga fan said...

If Cassandra proposes fed acting as a lender of last resort that breaks apart 5 or 10 of the biggest US bank, Cassandra is a man with a plan.