Reflections: Primate in Distress
By John Gilbert
November 21, 2012
The enthusiastic response of the capital markets to the Federal Reserve’s announcement of the third quantitative easing program is, of course, just what they intended.¬† It recalls the even more ebullient response to the ECB’s Long Term Refinancing Operation announcement late last year.¬† Interest rates are now largely useless as an instrument of monetary policy, residing at virtually zero, so a sheer quantity of money is now necessary to produce an effect upon economic behavior‚ÄĒspecifically, employment.¬† Central banks have gone further, however, in asserting their intentions henceforth.¬† The Fed has extended its time horizon to mid-2015 for maintaining such very low rates, and President Draghi of the ECB said unequivocally in July that they would do “whatever it takes” to preserve the euro.¬† At a time when there is massive uncertainty at the behavior of politicians, including the fiscal cliff in the U.S. and the outcome of the growth versus austerity debate in the Eurozone and U.K., there would seem little reason to be concerned at uncertainty at the behavior of central banks.¬† Indeed, the only surprise recently has been from the Bank of Japan, which unexpectedly enacted additional stimulus.¬† Developed economy central banks are headed in one direction‚ÄĒsupport the economy, support capital markets and support employment.
Yet the appearance of safety the central banks are attempting to create must eventually prove illusory.¬† Their behavior is unprecedented because economic conditions are also.¬† In Chart 1 we show the bank rate at the Bank of England since its founding in 1694.
Chart 1.¬† Bank of England Bank Rate
Sources:¬† Global Financial Data, GR-NEAM
In over three centuries rates have never been this low. ¬†They in turn reflect the weight of debt accumulation over decades leading to the financial crisis of 2008‚ÄĒ2009, demographics and innovation gone wild in the libertine financial world known as shadow banking.¬† In such uncharted territory, uncertainty is itself certain.¬† Unprecedented central bank policies are likely to contribute over time to uncertainty, if it is understood that they cannot go on forever.
In this sense firms making hiring and investment decisions are like the monkey in a behavioral experiment, and it is unsurprising that economic growth has been disappointing.¬† Uncertainty has received a lot of attention from researchers in recent years, particularly since the crisis.¬† Chairman Bernanke himself wrote one of the earlier papers on the subject in 1983.¬† The IMF in October of this year released its semiannual World Economic Outlook with a review of the research on the subject.¬† In particular they referred to the role of uncertainty about government policy concluding,
¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† “Empirical evidence suggests that uncertainty tends to be detrimental to economic growth.¬† The ¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† growth rate of output is negatively correlated with macroeconomic uncertainty...Policy-induced
¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† uncertainty is also negatively correlated with growth‚Ä¶”
Uncertainty is intangible and thus difficult to measure, but various approaches exist.¬† The most common measure is the volatility of stock prices, measured either directly or, more recently, using volatility implied in stock options.¬† A recent development is an index of economic policy uncertainty, specifically.¬† In Charts 2 and 3 we reproduce indexes of economic uncertainty and economic policy uncertainty, respectively.
Chart 2.¬† Macroeconomic Uncertainty ¬†¬†
Sources:¬† Bloomberg L.P., GFD, GR-NEAM
Chart 3.¬† Policy Uncertainty Index
Sources:¬† Baker, Bloom and Davis (2012), GR-NEAM
Chart 2 appears as one would expect, with a massive spike in the financial crisis.¬† This is to be expected after the government did not respond as lender of last resort in allowing Lehman Brothers to enter bankruptcy, upending 200 years of governments acting in such a capacity.¬† Chart 3 is timely, in that it shows a large and fairly persistent rise since the crisis.¬†¬† The economic policy uncertainty index in Chart 3 is from research by Baker, Bloom and Davis (2012), and is based upon three components:¬† the frequency with which terms such as “uncertainty” and “economic policy” appear together in the media, the number of tax provisions expiring in coming years, and the dispersion of forecasts of future government expenditures and inflation.
This work is a useful contribution to knowledge because it portrays increasing uncertainty even as central bank policies are intended to stabilize the economy.¬† It may underestimate the role that central bank policies themselves now play in creating uncertainty, however.¬† Certainly the central banks have done what they can to be unequivocal about their intentions.¬† But they do not control the remarkable conditions that produce Chart 1, and their choices over time may not be as unlimited as they appear at the moment.
There are two possible constraints on their future behavior.¬† One is rising inflation, and the other is the emergence of unintended consequences from their current policies.¬† In fact, some sort of inflation is virtually inevitable.¬† Inflation as conventionally defined is rising prices of goods and services.¬† Another sort of inflation is rising asset prices, and such unintended consequences are what concern us here.¬† This is particularly true because, at least in the U.S., inflating securities prices is a more or less explicit objective of the central bank’s policy, intended to inflate households’ perceptions of their own wealth with a presumed positive effect on retail sales.¬† Distortion of asset prices sends misleading signals about the cost of capital, however, and causes mistakes to be made in its allocation.¬† This is just what occurred in the last bout of easy central bank policy in the U.S. and, the Fed’s demurring on the subject notwithstanding, contributed to the housing bubble and subsequent bust.¬† We overlay in Chart 4 below the recent volatility implied in stock options, similar to data underlying Chart 2, with the same series during the U.S. housing boom.
Chart 4.¬† Equity Options Volatility Then and Now¬†
Sources:¬† Bloomberg L.P., GR-NEAM
The depressed level of perceived volatility in current data does not mean that certainty has returned.¬† The high level of uncertainty suggested by the economic policy uncertainty index in Chart 3 suggests that the capital markets are being distorted by the waves of liquidity from central banks, and that the apparent confidence expressed in the more recent series in Chart 4 has no firmer basis than it did at a similar point in the previous economic cycle.
We can show this by comparing the markets' expectation of future volatility against the contemporaneous measure in Chart 4.¬† In Chart 5 we plot the ratio of the price of volatility futures several months out against the market's assessment of immediate volatility.¬† Since the financial crisis, there has been a consistent upward tendency in this series.¬† There were downward spikes at the time of the crisis, and in 2010 and 2011 as the Eurozone crisis erupted, caused by the sudden increase in perception of near term risk.¬† As those episodes subsided, however, the markets' continuing uncertainty at the longer term future reasserted itself, and the rising price of insuring oneself against financial risk has continued to rise.
Chart 5.¬† The Rising Cost of Uncertainty Insurance¬†
Sources:¬† Bloomberg L.P. and GR-NEAM
The findings of high uncertainty and its implied cost to economic growth are evident in multiple indicators, from an economic policy index to futures prices.¬† Central banks are aware of the cost of uncertainty, but may overestimate their power to eliminate it.¬† It is embedded in the facts of the moment, and of the recent failures in governmental responses to crisis.¬† They may actually be making the problem worse over time.¬† The Federal Reserve has said that it will maintain exceptionally easy policy until 2015‚ÄĒbut what then?¬† They are engaged in the most massive experiment in economic history.¬† It remains to be seen if it will work, or if unintended consequences again arise that create new crises.¬† In the meantime, uncertainty itself contributes to the growth dilemma that they are trying to solve.¬† The monkey’s mood does not improve as the experiment intensifies.
Baker, Scott R., Bloom, Nicholas and Davis, Steven J., “Has Economic Policy Uncertainty Hampered the Recovery?” (February 7, 2012). Chicago Booth Research Paper No. 12-06.
Bernanke, Ben S, 1983. "Irreversibility, Uncertainty, and Cyclical Investment," The Quarterly Journal of Economics, MIT Press.
Bloom, Nick. (2009): “The Impact of Uncertainty Shocks,” Econometrica, 77.
IMF, World Economic Outlook, October, 2012
¬©2012 General Re-New England Asset Management, Inc.
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