In November, Viral Acharya, one of the deputy governors of the Reserve Bank of India, had warned the government of India not to incur the wrath of the financial markets. He has been proven right, but with a twist. First, the wrath of the financial markets has not visited India. It has visited the United States. Even there, it has not been felt by the government but by the Federal Reserve.
Therein lies the problem of invoking the financial markets to enforce policy discipline. Financial markets do not discipline policymakers, but they capture them, especially if they are central bankers.
Last week, reacting to the tantrums of the schizophrenic stock market in America, Jerome Powell, the chairman of the Federal Reserve, said that the rate-setting Federal Open Market Committee was listening carefully to the message from the financial markets. Thus, the parent has been suitably disciplined and the crying baby has got the candy.
The Federal Reserve, under Powell, has been trying to break from tradition, in vogue since the mid-nineties, of setting monetary policy in response to the preferences of the stock market. Unfortunately, it has received very little public intellectual support in its mission to restore meaning and sense to monetary policy.
Even sensible commentators, such as Stanley Druckenmiller and Kevin Warsh, have ended up offering muddled, confusing and contradictory advice to the US Fed. In an op-ed, Fed Tightening? Not Now, written in The Wall Street Journal on 16 December, the two authors advised the Federal Reserve to cease its double-barrelled blitz of higher interest rates and tighter liquidity.
If the Fed was shrinking its balance sheet by not reinvesting the proceeds of its redemption of treasury securities, the result should be seen in higher treasury yields. However, that has not been the case. Treasury yields have declined in recent months. Indices of financial conditions do not suggest that they have tightened significantly enough to affect economic outcomes in the country. Financial conditions remain too accommodative. More jobs are available in America than there are job seekers. The amount of debt with negative yields has jumped 46% in the last three months. In other words, liquidity is still excessive. It needs to be drained.
The muddled thinking of the authors comes through in their exhortation to the Federal Reserve to break from the old regime. Quite how the Federal Reserve would break from the old regime by yielding to financial market tantrums is beyond my comprehension.
It is impossible to break from the past in a painless manner. If intellectuals recoil at the first signs of pain and urge policymakers to stop in their tracks and if policymakers comply, the old regime will be securely intact.
In a well-crafted speech delivered in 2010, D. Subbarao, the then governor of the Reserve Bank of India, said: “There is a joke that if something works in practice, economists run to see if it works in theory. Actually, I don’t see the joke. That is indeed the way it should be.” However, economists, policymakers and investors are not learning from the practical world.
Ten years ago, the financial crisis of 2008 was, in part, a consequence of central banks ignoring, wilfully or otherwise, excesses in financial markets, while training their myopic gaze on conventional metrics of overheating and economic stability. It is déjà vu 10 years later. Those who won their Nobel prizes for rational expectations (no systematic errors) must do “award wapsi”.
Similarly, based on empirical evidence from repeated episodes, it is clear that the financial markets are neither informationally efficient nor are they useful price discovery mechanisms.
Action in stock markets in America since the third week of December have only confirmed their schizophrenic nature. Efficiency is the last thing that comes to mind when one thinks of stock market movements. Daily returns of more than 3% are not a feature of markets with normally distributed returns, the assumption that underpins many models of financial asset pricing.
Second, if stock markets were indeed signalling to the Federal Reserve that the economy was slowing, where is the evidence that the market is pricing in lower earnings from a slowing economy?
On the other hand, stock prices jump or swoon in response to shifts in liquidity. In other words, in the standard equation for the price of a stock, the numerator figures, but rarely in the calculation. It is all about the denominator—interest rates and liquidity. That is a sign of a casino that is happy with the free flow of money and not an efficient price discovery mechanism.
Clearly, the Federal Reserve did not have to be apologetic about draining the punchbowl. That it has been forced to do so suggests that an honest intellectual debate on monetary policy independence is overdue.
V. Anantha Nageswaran is the dean of IFMR Graduate School of Business (KREA University). These are his personal views.