Markets to Fed: Please leave us alone

By Greg Ip Markets Dow Jones Newswires

AP (Copyright 2017 The Associated Press. All rights reserved.)

Bond yields around the world have surged since the European Central Bank hinted last month that its bond buying was coming to an end, a replay of the "taper tantrum" in 2013 when the Federal Reserve caught markets off guard with similar plans.

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Both episodes are fodder for a view widespread in markets, that bonds long ago ceased to be an independent reflection of economic fundamentals and are now just a giant bet on what central banks do with their securities portfolios. According to this view, quantitative easing (QE), as this bond buying is known, zero to negative interest rates and detailed guidance on future monetary policy amount to market manipulation on a grand scale. Whatever the theoretical benefit to the economy, such manipulation muffles market signals, misallocates capital, and creates excesses that can come undone violently.

This critique has been around for years, but it stands to gain in prominence because it's shared by some of the people who may one day run the Federal Reserve. Janet Yellen's term as chairwoman expires next February and if President Donald Trump doesn't reappoint her, there's a good chance her successor will come from the financial industry. A banker or trader would not necessarily prefer higher or lower interest rates than an economist, but would be much less trusting of economic models and unwilling to deploy the exotic tools the Fed has used since 2009.

The Fed has been led by economists almost continuously since 1970. Its last two chairmen, Ben Bernanke and Ms. Yellen, are prominent academic macroeconomists. Their economic training underpinned their use of QE, zero rates and forward guidance as a way of stimulating demand, getting unemployment down and holding inflation at its 2% target.

Economists have broadly praised these tools for helping bring the economy back from the brink of depression in 2008 to today's low unemployment and inflation. On Wall Street, though, opinion has been much more ambivalent. This divide was highlighted by the 2013 taper tantrum, which Mr. Bernanke later blamed on traders' "unreasonable and entirely inconsistent" belief that QE would go on forever. Traders, by contrast, say the Fed didn't appreciate how QE had forced so many investors into the same trade, who all headed for the door at the first sign of a shift.

"Central bankers do not trust financial markets," says James Bianco, who runs a Chicago-based financial markets advisory firm, recently wrote to clients that they can fix every problem in the economy "except when those cretins in the financial markets go off half-cocked."

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Indeed, many on Wall Street think central bankers have an exaggerated sense of their power. Last year just before being named Mr. Trump's top economic adviser, Gary Cohn, president of Goldman Sachs Group Inc., said the Fed was undercut by forces beyond U.S. borders: "They're constrained by the rest of the world and ... the strength or weakness of your domestic currency." Mr. Cohn, who will lead the search for Ms. Yellen's successor, is widely considered a candidate.

Randall Quarles, a private-equity executive nominated as the Fed vice chairman for regulation, last year claimed that " Years of near-zero interest rates have led to a rise in speculative positions across a wide range of asset classes, as all financial institutions find themselves under intense pressure to seek adequate returns."

Kevin Warsh, a former investment banker who served with Mr. Bernanke on the Fed until 2011 and now serves on an outside advisory council to Mr. Trump, is also considered a potential Fed chairman. Mr. Warsh, a scholar at the conservative Hoover Institution, has criticized the Fed for changing course too often in response to noisy economic data and swings in asset prices, for believing it can manage interest rates and the dollar precisely enough to precisely target inflation, unemployment and economic growth and for treating markets "as a beast to be tamed, a cub to be coddled, or a market to be manipulated."

A Fed under Mr. Warsh would presumably change course less often in response to new data or market movements, nor mind that inflation is a bit below 2% as it is now, and deeply reluctant to engage in QE or cut interest rates to zero.

Yet are these realistic prescriptions? Donald Kohn, who was Fed vice chairman under Mr. Bernanke, says the Fed needs to operate through markets to achieve its goals of low unemployment and stable inflation and thus it will always have to care about stocks, bonds, and the dollar, which in turn will be driven in part by actual and expected Fed policy. "It was true when rates were 5%, and when they were 0.125%." Nor can the Fed simply ignore short-term data because it's noisy because, he says, it may also contain a signal. Nor should the Fed forswear tools like QE which may be necessary if, in the future, interest rates hit zero again.

And it's hard to argue with results: Unemployment is back to prerecession levels, and if unconventional monetary policy isn't the main reason why, it has hardly generated the calamities many critics predicted. Inflation did not skyrocket, no new financial crisis has come along, the dollar has not collapsed. Nor are Ms. Yellen and her colleagues oblivious to the distortions the Fed's huge balance sheet may cause. It's one reason they seem determined to start shrinking it in coming months. Every economist at the Fed learns a healthy respect for markets. Any financial pro who succeeds Ms. Yellen should have a corresponding appreciation for economics.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

July 19, 2017 07:57 ET (11:57 GMT)

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