Central Bank Myths

The main characters in myths are usually Gods, Supernatural heroes or some kind of special human and looking at the current crop of Central Bankers, at least in how they are viewed by the world’s media, finance industry and by investors alike, one could perceive a combination of all three of these traits.

The ever frequent round of meetings, whether they be G7, G20, IMF, World Bank, BIS, OECD have transformed into something akin to the Oscars, with delegates whisked in by limousines to a red carpet welcome with wall to wall camera flashlights.

Four years of rising stock prices, despite economic growth remaining lackluster, have been credited to the co-coordinated activity of the CBs and in particular to their maintenance of historically low interest rates. Is this true?

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Exhibit 1, your honour, seen above, isn’t a map of the London underground, but a comparison of the FOMC rate, better known as the Fed funds rate, which the “alpha-dog” of CBs, the US Federal Reserve, meet up to discuss and possibly amend interest rate policy at roughly monthly frequency. The Fed funds rate is shown in black and one can note that the rate has fallen from 6.5% back in 2000 to 0.25% in late 2008, since where it has remained. Also shown are the following:-

  • The 3 month money market rate
  • The 2 Year Treasury Bond Yield
  • Official” US Inflation, known as the CPI

The 3 month MM rate and the 2 year yield are set by the market (albeit that there appeared to have been a bit of fixing going on by our banking friends but that was marginal.)

Point one to observe from the chart is that inflation really has nothing to do with any decision on interest rates, else US rates would currently be at 3.5% – 4% pa, rather than the 0.25% actual. So we’ll call that Myth 1 demolished, that CBs are slavishly concerned over inflation.

Myth 2 is that CBs (and the above chart could be replicated for any Central Bank on the planet, not just the Fed) actually control the Fed funds rate/ or bank rate. A closer inspection of the Fed fund rate against the 3 month MM rate shows that the former slavishly follows the latter, in other words CBs have never made a proactive decision in their lives, the market leads and they follow. They are reactive.

Aside of QE 1 and 2, the Fed last year announced that, “it will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates.”

Furthermore, the Federal Reserve’s QE3 statement of last September also mentioned the aim of a “downward pressure on longer-term interest rates.” but look what has recently happened to the yield of the 30-year U.S. T-Bond yield. They have risen and risen substantially, by 34% since the July 2012 low.

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The 30 year yield is of more importance in respect of mortgage costs and hence the one that the Fed has been “desperate to control

It’s not that they have failed miserably in their stated goal, we’ll take that as a given, it’s the fact that they have never had any control over interest rates in the first place, it’s the market that decides.  And the market is the collective human herd who makes day to day decisions of whether they wish to loan governments money and if so, is the market rate being offered conducive with the risk being taken.

Patently, since July 2012, the market participants have decided that they wish to be compensated with a higher interest rate, so expect the CBs to follow shortly, regardless of the myth 3, controlling longer term interest rates.

In fact why bother having Central Banks at all?

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