Non-Standard Measures Are Risking Stability

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Gregory Marks's picture

As someone who manages a foreign exchange and macro ETF portfolio, when central bankers are speaking I am likely listening. Although some financial media sources exaggerate the impact that these voices have on day to day market fluctuations, those who set monetary policy can have a large directional impact on interest rates around the globe. Those shifts in interest rates vis-à-vis policy or forward guidance adjustments often create ripples throughout money markets, global equities and foreign exchange rates. 

But where did these mechanisms of setting interest rate policy come from? As detailed in the Lords of Finance (a Financial Times and Goldman Sachs Business Book of the Year), in November 1910 a group of financiers gathered in Jekyll Island to form what would become the Aldrich Plan. This plan led the groundwork for the Federal Reserve Act that passed Congress in 1913 and established a central bank for the United States, the Federal Reserve. 

Lords of Finance focuses on the history of monetary policy and central bank creation in the early 20th century. The author, Liaquat Ahamed, goes through copious amounts of research to identify the faults of these early central bankers during the Great Depression. Ahamed takes the view that those at the Federal Reserve and Bank of England failed to take extraordinary measures to prevent such an economic collapse. Those views may sound familiar as a recent scholar of the Great Depression, a man by the name of Ben Bernanke, found himself in a similar situation as those early central bankers. Bernanke argued and continues to argue that the events of 2008 warranted unprecedented measures (they did) and that a failure to do so would have repeated the Great Depression on an even larger scale (correct as well). 

Although Lords of Finance rightly criticizes central bankers of the past for doing too little, the next Business Book of the Year focused on monetary policy may likely argue that central bankers of the last few decades have done too much. 

This is the view I hold despite the fact that it goes in the face of current central bank forecasts and opinion. This is also the view of former managing director of the IMF and current Reserve Bank of India governor Raghuram Rajan. As the Financial Times notes in their recent summary of Raghuram Rajan's latest comments, there is currently a build-up in risks that have directly resulted from central banks’ unprecedented measures, of which are in the fifth year of implementation. 

A recurrent problem among central bankers is that they are often behind the curve. Because a majority of monetary policy makers are career academics or have remained in a central bank capacity, their experience in markets is limited in comparison to those on a trade or strategy desk in the private sector. Economic models cannot predict a crisis and if they can it is already too late. It takes a comprehensive knowledge base in market flows, psychology, technicals and structure to identify a mismatch between price and underlying medium-term fundamentals. 

“Financial sector crises are not as predictable [as those of economic growth].” Rajan said. “The risks build up until, wham, it hits you.” 

(I have respected Rajan for some time now. He was one of the only central bankers sounding the housing alarm in 2005 while others were highlighting the ‘strong fundamentals’ to prices. Earlier in the year I shared my confidence in him as head of the RBI and argued that the Rupee would likely strengthen into 2014, although in April I highlighted an overvalued Rupee where INR could weaken versus the greenback into the third quarter). 

It is important for market participants and policy makers to listen to Rajan at this critical juncture. On almost every structural, technical and strategic basis I observe, I see a dangerously overextended environment much like Rajan. Economic models can view risky assets in the context of inflation adjusted price over time, but they fail in the most crucial capacities. Economic models cannot predict the evaporation of liquidity and the circular intensifying of selling momentum during demand, price and rate shocks that come with it on average every five to six years. A low rate environment, although in place to boost demand/prices, help overextended financial institutions and reduce longer-term unemployment/rates, also has the impact of boosting shorter-term leverage, risk taking and the appearance of liquidity.

Although no one can profess to predicting the future, the idea that this can be unwound steadily is, to quote Rajan, “…a big hope and prayer.” Although the Lords of Finance during the Great Depression did too little to avoid catastrophe, we cannot ignore what may be the result if today’s Lords of Finance have done too much.