The ignorance of markets
There is considerable debate about whether markets are efficient, and whether investors are rational. To me it is self-evident that investors at times are anything but rational and markets at times are anything but efficient, but I will leave the economists to argue about that. If anyone really wants to know more about the limitations of the efficient markets hypothesis, read this post by Euronomist. And for more on whether or not human beings really are rational utility maximisers - as is implied by the rational expectations hypothesis - read this post by John Aziz.
When it comes to monetary policy, though, all too often we are not dealing with inefficiency or irrationalilty, but simple ignorance. In an interview on Reuters TV recently, Ashraf Laidi, Chief Strategist of City Index, a leading FX trading company, said this about the UK's monetary policy:
"But bond traders will continue to push yields higher as long as the Bank of England shows reluctance to taper these asset purchases. That's something that has not even been mentioned about the UK. So probably we need to start looking into when the Bank of England is going to reduce its £375bn of monthly purchases. These have to be reduced some time before we talk about higher rates."
Now there are a couple of very obvious errors in this. The Bank of England is not currently doing QE: the size of asset purchases has remained at £375bn now for nearly a year. So we are not talking about "tapering" in the US sense, i.e. gradually reducing the size of monthly asset purchases. There are no monthly asset purchases in the UK. Indeed there never have been: UK QE was never done on a regular monthly basis. It seems the Chief Strategist has got his countries mixed up.
What Laidi means by "tapering" in this case is reducing the size of the Bank of England's balance sheet by selling assets and draining excess reserves. That is a very different matter from the situation in the Fed, where "tapering" would simply reduce the rate of expansion of the Fed's balance sheet. The Bank of England's balance sheet is not currently expanding - indeed it will soon start shrinking naturally as its stock of assets matures, unless the Bank makes more purchases to replace those that mature.
But Laidi's assertion that the Bank of England's £375bn stock of assets must be reduced before we can even talk about rate rises is simply wrong. The fact is that the Bank of England does not have to sell its assets before raising rates. Laidi's assertion is contradicted outright by Mark Carney, the Bank of England's Governor, on p.20 of his written evidence to the Treasury Select Committee (my emphasis):
"To ensure the MPC retains adequate room to respond to developments in economic conditions, it will be sensible for any tightening in monetary conditions to come about first through an increase in Bank Rate that could, if necessary, be reversed easily. In systems like the Bank of England’s, in which reserves at the central bank are remunerated, there is no obstacle to raising short-term interest rates before the size of the central bank’s balance sheet is reduced."
Carney subsequently confirmed this in his interview with the Treasury Select Committee on 12th September 2013, stating categorically that "the rate rise would come first".
Carney's observation that remuneration of central bank reserves enables exit from QE without reducing the size of asset purchases is important, because it gives an indication of the Bank of England's likely exit strategy. To return to using the base lending rate as the primary monetary policy instrument, excess reserves have to be drained from the financial system, but that doesn't necessarily mean that assets have to be sold. As Peter Stella points out in this excellent article at Vox, Peter Stella, raising interest rates is itself a QE exit strategy:
"Central banks to exit by raising interest rates, not by shrinking balance sheets".
Stella then goes on to discuss a number of ways in which the Fed could exit from QE without selling assets. Although the Bank of England's monetary policy framework works slightly differently from the Fed's, in that the Bank explicitly sets the base rate rather than influencing a funding rate via open market operations, Stella's strategies would also be appropriate in the UK. Carney's remark suggests that he is considering raising the interest rate on reserves in order to pull the base rate upwards. Stella notes that this approach is not without its problems - although the Bank of England would not be concerned about having the main policy rate set by fiat, since that is in effect what it already does anyway. Nonetheless, in due course the Bank of England will probably also consider term deposits and reverse repos as alternative ways of draining reserves without selling assets. And as Shaun Richards suggests, it may also allow part of its asset stock to mature naturally, though that would take some years. Personally I doubt if either the Fed or the Bank of England has the slightest intention of significantly reducing their asset holdings even after rates start to rise. They are much too useful as instruments of monetary policy.
I suppose it is possible that bond traders are pricing in asset sales ahead of rate rises, as Laidi suggests: that would explain why yields are rising in apparent defiance of the Bank of England's forward guidance. But really this makes no sense. Pushing yields up could actually encourage the Bank of England to do more purchases to force them down again. So either our bond traders are ignorant, thinking asset sales will happen before rates are raised and pricing accordingly: or they know that rate rises are not dependent on asset sales and won't happen any time soon anyway, but are forcing up yields because they want the Bank to do more purchases. Frankly I hope it is the latter: ignorant bond traders are far more dangerous than those who know what they are doing. But I fear it is the former. If Laidi can get this so wrong, how many other traders and strategists are there who also haven't bothered to find out what QE exit is likely to look like?
I am pretty appalled that a senior strategist apparently knows so little about the workings of monetary policy, given the influence that central banks have on markets (and vice versa). And I wish I could be confident that Laidi is the only one. But he isn't.
The following day, also on Reuters TV, Peter Shaffrik, Head of European Rates Strategy at RBC Capital Markets, completely failed to understand Carney's remark to the Treasury Select Committee that "under the right circumstances" a steeper yield curve implies looser monetary policy:
"Not too long ago we have been told it's a very good thing that asset purchases (QE) has helped keep the long end rates down. Now a steep yield curve even with very short front end rates obviously implies higher long end rates. And that's a bit contradictory".
If Shaffrik had listened to the next part of Carney's evidence he would have heard the explanation for this apparent contradiction. But it doesn't take a great deal of imagination to work it out. It all depends what behaviour you are trying to influence with monetary policy. If the aim is to discourage saving and encourage spending - to bring forward consumption to the present - then depressing long-term rates makes sense. But if what you are trying to do is encourage lending for investment in longer-term projects, then steepening the yield curve does indeed constitute looser monetary policy. Lenders engage in maturity transformation - they borrow short and lend long. Depressing short rates and steepening the yield curve reduces funding costs and improves returns on longer-term lending, which should encourage banks and other financial institutions to lend. As a major cause of the slow recovery has been a massive failure of private investment (and public, but that's another story), it makes complete sense for Carney to address that by adopting a policy that flattens the short end of the yield curve and steepens it beyond 2 years:
To me, the behaviour of markets in relation to monetary policy suggests that most traders and strategists haven't a clue how it works. They base their strategies on irrational assumptions formed from prior beliefs, many of which are known to be wrong - such as the widespread expectation that QE will increase inflation when there is not a shred of evidence that it has ever created significant inflation in any country where it has been used for any length of time; the irrational belief that excess reserves necessarily lead to more bank credit, when the fact is that banks cannot and do not lend out reserves; and the equally irrational belief that rising bond yields are always a bad sign for an economy, when for developed economies in a slump rising bond yields can actually indicate that economic prospects are improving. This last is particularly irritating, because trading strategists of all people really should understand the pro-cyclical nature of bond investments. People invest in bonds when they have little confidence and are therefore risk averse. QE leans against this tendency by reducing the yields on bonds to encourage investors to diversify into riskier assets. And it has achieved this, but unfortunately the result has not been increased domestic investment: instead the money has gone into emerging markets. Hence Carney's change of strategy.
The ignorance of markets regarding QE and interest rate policy is particularly galling because central banks have produced numerous papers on QE and its exit, as have institutions such as the IMF and the BIS. And the effects of QE and strategies for exit have been extensively discussed in the economics blogosphere, where much of the really good research and analysis into the effects of monetary policy is to be found - from Interfluidity and Scott Fullwiler, for example, plus of course FT Alphaville's excellent posts. So strategists have had plenty of opportunity to find out what the effects of QE and ZIRP really are and develop informed views as to what a credible exit strategy might look like. That they don't appear to have done so is frankly inexcusable. The argument that monetary policy is "difficult to understand" simply won't do. These people design trading strategies and shape markets. It is their job to get it right - and in these days of central bank dominance, that involves taking the time and trouble to understand how the monetary system really works and in what ways monetary policy influences markets. And they are paid a lot of money to do this. If the comments from Laidi and Shaffrik are representative of market strategists' views, I frankly wonder whether they really earn their keep. In market making, ignorance is incompetence.
FT Alphaville's numerous posts on QE
QE myths and the Expectations Fairy - Frances Coppola (Coppola Comment)
The QE Debate at Coppola Comment.
So you start to follow the money - Barnejek
Treasury Select Committee 12 September 2013 - Parliament Live (over 2 hours long - stiff brandy recommended! Sound missing for first 4 minutes)