Boringness of Central Banks To Blame for Bubbles

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As former Federal Reserve chairman Alan Greenspan argues that the pre-financial crisis bubble was the result of mortgage rates megabanks subprime expansion a global savings glut simply (uncontrollable) appetite for risk, we present you with a rather different, more amusing, theory.

From Deutsche Bank’s Francis Yared and Abhishek Singhania:

We argue that in fact, that central banks' predictability during the 2004-2007 tightening cycle contributed to the compression of the risk premium in fixed income markets and, therefore, indirectly to the excessive leverage that built up over that period.

In other words, central banks were simply too boring. Mass ennui took over the markets.

To evaluate central banks’ predictability, Deutsche Bank compares market and economist forecasts of interest rates one and three-years ahead, with what they actually ended up being.

Here’s the methodology:

We define the market forecast error 1 year (3 months) ahead as the absolute value of the difference between the 1Y3M (3M3M) forward rate and the 3-month rate realised 1 year (3 months) later. Similarly we define the economists' forecast error as the difference between Consensus Economics' average forecast and the 3-month rate realised 1 year and 3 months later.

And the results:

According to Deutsche then, the table indicates that the Fed was far more predictable in the 2004-2006 tightening cycle, than in comparison with previous tightening ones. In other words, the margin of error between market and economist forecasts substantially dropped in the years before 2007.

Here’s what the German bank says:

Unsurprisingly the better forecast accuracy has also resulted in lower volatility of the 3M rate during this tightening cycle and the associated lower risk premium and lower long-term rates. At the time, being boring was a virtue for central banks, and the predictability was itself possible because of the Great Moderation and lower economic volatility. Nonetheless, with the benefit of hindsight, central bankers should bear in mind the impact on risk premium (and longer-term rates) of being too predictable.

Central banks too predictable?

Interesting — especially as the market now waits with bated breath for the Fed to begin tightening, scrutinising the US central bank’s “extended period” of low interest rates language for all its worth.

Perhaps Mr Ben Bernanke — Greenspan’s successor — would be willing to shake it up a bit?

Related links: Greenspan mauled over role in meltdown – FT Citi’s supersafe CDOs? Puh-lease – FT Alphaville Pricing risk redux – FT Alphaville Greenspan says, je regrette quelque chose – FT Alphaville

This entry was posted by Tracy Alloway on Monday, April 12th, 2010 at 12:01 and is filed under Capital markets, People. Tagged with alan greenspan, bubble, crisis, federal reserve, interest rates, Monetary policy. Edit this entry.

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