Central Bankers Really Don't Know What They're Doing

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On June 5, 2008, ECB President Jean-Claude Trichet shocked markets by hinting at a shift in monetary policy. Given the date and setting for all the fuss, you would be forgiven if, having no prior knowledge of European monetary affairs in 2008, you prejudged that the ECB was finally joining the rest of the world's central banks in "stimulus." That was not the case, however, as Trichet suggested that the ECB's next move early that summer might be to raise interest rates.

Less than a month later, on July 3, 2008, the ECB governing council voted to do just that. At that time, calculated HICP (Harmonized Index of Consumer Prices) was surpassing 4%, more than double the central bank's inflation target. Even though there were ongoing hints of distress worldwide, the ECB felt that enough had been done by those who needed to do it (Fed) in order to successfully navigate the potential downside (echoing the message coming out of the FOMC which was cautious optimism after Bear Stearns). At the press conference accompanying the rate decision, Trichet said:

"They [HICP inflation rates] are expected to remain well above the level consistent with price stability for a more protracted period than previously thought. Moreover, continued very vigorous money and credit growth and the absence thus far of significant constraints on bank loan supply in a context of ongoing financial market tensions confirm our assessment of upside risks to price stability over the medium term."

Even though Eurozone GDP in Q2 was much weaker than what would typically confirm such an assessment, the ECB had judged that a "technical counter-reaction" relating to much stronger GDP in Q1 2008. Further, it was expected the global economy would decouple from whatever US weakness was most apparent if ever the possibility monetary "stimulus" in the US proved insufficient (which the ECB judged unlikely).

"While moderating, growth in the world economy is expected to remain resilient, benefiting in particular from continued robust growth in emerging economies. This should support euro area external demand. As regards domestic developments, the fundamentals of the euro area economy remain sound and the euro area does not suffer from major imbalances."

Calculated HICP inflation in Europe peaked, coincidentally, in July 2008 though not for the reasons suggested by Trichet and his monetary policy views. It should be quite distressing that supposed experts about monetary conditions and how they relate to the real economy could be so wrong about, well, everything. This is all the more so given that the US Federal Reserve and Bank of England took the opposite approach and still ended up in the same place anyway. In other words, no matter which direction any central bank took, none of it mattered; markets and the global economy crashed regardless of any monetary policy setting.

There was entirely too much faith in their own abilities, as the Financial Times described concurrent to the ECB's July 2008 rate hike:

"Mr Trichet's shock announcement last month that the Frankfurt-based central bank was mulling an interest rate increase highlighted the change in mood among global policymakers away from concerns about the impact of the financial market crisis on growth to focus more on rising inflation risks."

They, meaning any central banker, really thought that the events surrounding Bear Stearns was the worst of it and that all the powerful "stimulus" (in the US that meant "huge" accommodation of bringing the federal funds rate target all the way down to 2%!) would lead the economic charge into the immediate future where all the bother of late 2007 and early 2008 would be quickly forgotten. Instead, what was forgotten was how monetary policy had been revealed and proven futile.

Leave it to Jean-Claude to confirm as much, as not even three years later he did it again! Disregarding the dramatic events of 2010 (PIIGS), coming so soon after 2008 and 2009, no less, the ECB on April 7, 2011, voted to increase their overall interest rate corridor (three major central bank rates make up that corridor) with the midpoint or Main Refinancing Rate (MRO) set to rise from 1% to 1.25%. After bottoming out in July 2009 at barely above zero, Eurozone HICP had moved back above 3% for the March 2011 reading. Again, the Financial Times succinctly described the setting:

"The increase in the ECB's main interest rate, from 1 per cent to 1.25 per cent, follows a surge in eurozone inflation and increasing confidence at the Frankfurt-based institution that official borrowing costs no longer need to remain at emergency lows."

Throughout that period, the European financial system had undertaken further radical deformation relating to PIIGS sovereign debt and no true end in funding issues (especially "dollars"). In May 2010, the ECB was "forced" to initiate its Securities Market Programme (SMP), which began a seemingly unending series of European central bank "buying." Trichet had judged it by early 2011, along with the Fed's return to QE with QE2 in the fall of 2010, to be enough. The quarter-point rate hike in April 2011 was followed by another that July - and then chaos; again.

It was the exact same scenario as 2008 only resized in scale by that panic no economist or policymaker saw coming. The SMP was shelved in September 2012 but not before Trichet was. In June 2011, Mario Draghi was appointed to succeed Trichet when his term expired that October. One of his first actions was to lead the ECB to reverse the summer's rate hikes, with the first cut effective only 9 days after the change in leadership; Draghi is still cutting, or trying to.

Twice in three years monetary policy in Europe (and not only Europe) was led far astray by nothing more than oil prices. In the summer of 2008, oil had surged even though the financial state of the world was fatally compromised. In fact, the very reason for the jump in oil prices might have been, as I would argue, because of that funding condition. In a world where internal financing runs on collateral and where the dominant form of collateral was actively being repudiated, anything else will do no matter how seemingly ill-suited. There was no shortage of cash especially in certain places, as witnessed by the tendency of the effective federal funds rate to run shallow to the target at times of increasing stress, so it was only a matter of process by which those with cash would find something collateralized to do with it.

The events of 2010 were entirely too similar, meaning that the funding problems then were not just the mess of PIIGS fiscal situations, but rather once again collateral rejection and abandonment. In what was a tragic trend of irony, banks that had been using "toxic waste" MBS collateral before 2008 had in far too many cases switched to sovereign government bond collateral especially immediately after - all because sovereigns had accrued the ideal of "risk-free" without anyone ever paying too much attention to what that really meant. The expression "out of the frying pan and into the fire" fits here perhaps more than anywhere else it has been used.

Oil prices had risen like a phoenix from the depths of the 2008 collapse on renewed hope that all the combined "stimulus" would be enough to allow financial normalization so that the global economy's believed temporary deviation from its prior trend/potential would be as short as possible. The events of 2010, especially that May, and then the "need" for more "stimulus" later that year already had called into question that view. Oil prices peaked in April 2011, with WTI above $110 and Brent fixing to break $120 again. It was never to be, though, as the worst possible condition developed; oil traded sideways mostly around $90 to $100 for another three years.

In terms of orthodox "inflation", a steady oil price is "deflation." If oil prices rise from $75 to $100 as they did, roughly, from August 2010 through April 2011 that "contributes" 33% "inflation" from one of the most measured commodities. If, however, oil only stays at $100 or drops slightly from that point onward, it becomes a significant drag upon "inflation" whether HICP, CPI or anything in between.

If there was any difference between Mario Draghi and Jean-Claude Trichet, it was that Draghi was and remains entirely more aggressive. The SMP was, again, replaced with something called the OMT (Outright Monetary Transactions), which "freed" the ECB from sterilization pressures Trichet had abided by. The initiation of and transition to the OMT came only weeks after Draghi's infamous promise to "do whatever it takes." It was odd timing to begin with since barely six months before uttering the phrase he had seemingly done just that.

In late 2011, as financial conditions once more looked panicky (and rumors of more potential bank failures swirled), the ECB had gone seemingly in the "bazooka" direction with the LTRO's. At the conclusion of the second of those monetary efforts, the ECB had expanded euro "liquidity" by nearly one trillion. While the banking sector did calm down, the PIIGS issue did not (which was the impetus for the July 2012 "promise") and the LTRO's did nothing in the real economy which was suggested as all-but-guaranteed by their size.

The 3.3% inflation rate (HICP) registered in April 2011 was repeated in September, October and November of that year even though "liquidity" and the global funding or financial shape was at that time its post-crisis worst. As the LTRO's came online, however, the HICP contradictorily started to fall and has yet to stop. The February 2016 HICP was -0.2% and below zero for the second time in less than a year, worse than the worst of the 2009 experience. In short, no matter what the ECB has done it has made no difference whatsoever (I'm sensing a pattern).

And the catalog of that monetary effort is long and full of "bazookas." You would again be forgiven if having not paid much attention to European monetary affairs under Draghi's term you were left with the impression the ECB has been largely silent or uninvolved for most if not all of it. That is exactly how monetary policy in Europe is described in the mainstream, as if each time the central bank is "forced" to react to conditions it represents the first time. Repeated failure is treated as if all prior acts just didn't exist.

That brings us to the events of yesterday, where the latest ECB expansion comes after the one that less than a year before it was also hailed as the "bazooka." They get bigger and bigger but in common they only share how much they will be forgotten in relatively short order (Japanification of not just the European economy but its monetary policy as well).

The nemesis for all of those prior efforts (a negative deposit rate, T-LTRO's, narrowed monetary corridor, a third covered bond purchase program, another ABS purchase program, a more negative deposit rate, QE, yet an even more negative deposit rate; and that is just since the June 2014) has been oil prices. The ECB started into NIRP in early June 2014 and barely a month later oil was into its (ongoing) crash. First, oil prices were described as temporary and transitory as surely investors (even those eternally damned speculators) would bid up oil once they saw and appreciated just how much "stimulus" there was and how effective it would be not just in Europe but globally.

But where "transitory" oil meant a temporary crash to around $45 at worst, a year later finds oil not just ignoring all the "stimulus" and central bank proclamations but trading lower still; below $30 at the most recent low point. And still the "stimulus" is offered, bigger and better we are told as if all the fuss about "quantitative easing" wasn't accurate in either of those words. If the ECB, as Bank of Japan and Federal Reserve before it, has to adjust the "Q" part it wasn't really so much quantitative as a guess to begin with; the lack of "inflation", even the slightest hint, suggests "easing" isn't the proper terminology, either.

In May 2014, just as the ECB was flirting with negative rates in a fitting bookend of pure impotence to its July 2008 rate hike, the Federal Reserve published a paper (first draft) that studied the effects of the SMP. To the surprise of perhaps only economists, they found no direct effect whatsoever searching the history of PIIGS spreads and yields. That did not mean, however, the study found nothing of SMP influence:

"This program was designed to improve market functioning and restore the monetary transmission mechanism within the euro area. This paper does not test those ideals. Rather, we test whether SMP purchases systematically lowered peripheral yields and spreads. We find limited evidence of purchase effects but large announcement effects. In addition, on days in which the ECB was believed to have made large purchases, yields moved down, independent of the size of the ECB's purchases or even if the ECB conducted any purchase at all that week. In all, we conclude that the ECB's SMP influenced yields through a confidence channel rather than through any direct purchase effect."

Even though those conclusions are narrowly reached upon study (regressions) of only the SMP which even many ECB central bankers hated, it is appropriate as a microcosm of what central banks actually do and really captures what they have done. The entire point of interest rate targeting, for example, is a "confidence channel." Once central banks departed the realm of actual money (targeting reserves, for example, when reserves were actually reserves) they initiated what has become a test of wills. Prior to August 9, 2007, there was very rarely need for even the smallest actual and direct test of central bank ability to enforce their monetary policy targets (Open Market Operations). Indeed, the level of "bank reserves" was almost non-existent in the US until Lehman Brothers. After that date, however, it has been nothing but ongoing restiveness that in very general terms is the markets, acting through the real economy, telling central banks to "put up or shut up"; to live up to the myths that they themselves have carefully crafted under these "confidence channels." Central banks simply cannot, a fact (not conjecture) they demonstrate repeatedly by their own repetitions.

That is among the primary reasons why past efforts are so studiously ignored once they are surpassed by the next - and they always are. Even in the United States, the FOMC has "raised rates" but is already suggesting, hinting and making preparations (which is what all the suggesting and hinting really is) for negative rates here - even though four QE's were done in similar "bazooka" fashion. "Inflation" in the US has followed almost exactly the same path as Europe despite any perceived differences in the willingness of the Fed versus how the ECB has been described. Again, as 2008, no matter the policy differences the end result is the same.

The reason for that is because central banks in the wholesale framework are all style and no substance. You can make the case that there are at least some detectible effects from all this monetarism, but those are, as the Fed study above suggests, limited to altering purely financial conditions and prices (and even then the calculated impacts are murky and often far too inconclusive given the scale of each interference). That is not the goal; it was never the goal. Financial intervention is supposed to be the means to accomplish real economic ends, the very recovery that continues to be elusive and avoided even though it has been nearly a decade of constant "accommodation" and "stimulus" the world over.

As I wrote a few days ago in anticipation of the ECB's madness, we have only continued to plumb the depths of absurdity about QE and really monetarism in general. "It becomes the circular logic of monetarism, as if QE works because QE works. When it doesn't work, more QE is the answer because it works." It does not matter, again, what QE actually does or how it is supposed to, all that matters is that someone, somewhere believes it does something and starts to act on nothing other than that belief. That is the "confidence channel" and it begins to explain oil prices among other factors.

If nothing you do actually produces the results you predict, over time there won't be any belief left in anything you would propose. The answer to that deficiency has been size and scale - always a bigger "bazooka." It creates the somewhat plausible override that if prior acts failed then it was due perhaps to execution rather than entirely flawed premises. Having to scale and up and repeat several times, however, removes even that variable.

Instead, market participants might get at first the fuzzy sense to actually examine the full track record of what central banks and monetary policy actually accomplished. I'm referring to far more than the generic, manufactured image of Ben Bernanke's "heroism" that conspicuously applied to only after the panic and Great Recession were all over (or Draghi's record only in the immediate aftermath of his promise), but really how incompetent and inept central bankers have been this whole time. A serious examination leaves no other conclusion even though in the media they are still described in reverential tones fit for the most stoic philosophers of ancient ideals, the wisest stewards of great duties and sacred tasks; look behind that PR veil, however, and you find the Three Stooges, the Keystone Cops, nothing but farce unsuited to any small task let alone the self-assigned "duty" to manage and plan the whole economy here and everywhere else.

Oil prices are the key and in many ways they always have been; the great confluence of the financial world of virtual "money" and the real economy that no longer much listens to broken promises no matter how many times they are rephrased.

It is a consistency that started long before QE and one that is shared in every jurisdiction occupied by practiced orthodox monetarism. The phrase that I passionately and forcefully hope becomes permanently associated with this monetary age, stamped in every history book yet to be written about it, is "they really don't know what they are doing." It should have been obvious on that count in 2008 and really 2007, but the fog and urgency of that time prevented full appreciation of the scale and nature of the failure - aided further by the continual obfuscations of central bankers themselves. There is no money in monetary policy. They still call it stimulus as if the word itself were the whole point; in most ways, it was and is.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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