Capco Blog

Bernanke’s decision not to start QE3 has wider implications for the markets than might first appear

For a few days prior to the highly anticipated speech of the Chairman of the US Federal Reserve, Ben Bernanke, at the meeting of central bankers in Jackson Hole, Wyoming, the markets were in a state of flux. Reeling from weeks of severe market turmoil (The Dow Jones Industrial Average had fallen from 12,724.41 on July 21st to 10,817.65 by August 19th and the FTSE 100 had fallen from around the 6,000 mark in early July to just over 5,000 by August 19th) the markets were looking for some good news from Bernanke that he would start supporting the markets by yet another dose of monetary easing.

Most market commentators had suggested, or threatened, that without another bout of monetary easing, or QE3, the floors would open from under the markets and we would be facing Armageddon. Well, we all heard the speech and there was no suggestion that another round of quantitative easing was in the offering and yet the markets reacted positively to the news. This is quite astonishing, if not bizarre. My question is, what exactly was provided in his speech that the markets did not know already? What new information did he share with the markets? Nothing. And in fact he suggested that due to the risks to the economy he would extend their FOMC meeting in September by one day. Hardly the kind of news that would result in the kind of optimism that we are seeing in the markets.

For me personally, the most interesting deduction is that central bankers are probably getting tired of being dictated to, or bullied, by the markets, and the markets have recognized this fact. The investment community has got used to getting what it wanted during the recent crisis and would cry foul every time it did not. To get their way, the markets would punish indices or yields until the central bankers and governments responded. I think they have now realized that this cannot go on for too much longer.

The second issue for me is that I suspect that the leadership at the Fed have realized the limitations of quantitative easing. After two huge monetary stimuli the economy is still in a pretty bad shape and few would bet against another recession. The only problem is that it might be even more severe than the one we just lived through and our tools are significantly blunter than they were two years ago.

If one buys that argument, and I am not sure how many will, then it begs the question why is the ECB not using the same tool? Why did it start buying up Italian and Spanish debt, legally or not? Who knows what would have happened if the markets also felt that they would themselves need to find solutions to their own problems, rather than constantly expect taxpayer funds to be used to make sure they make profits on their bets. Would they not be willing to also share in the pain?

If we have learned nothing else from the recent crisis, we have learned two things. The first is that central bankers can be as wrong about their predictions as anyone else. QE1 and 2 have not been able to avert a follow-up slow down, despite all the assurances. I won’t get into how wrong the ECB was with its own predictions. The second is that the markets have got used to taking bets that have significantly more moral hazard than previously. Now, they demand that their bets be made profitable no matter how wrong it was at the time they took it. And so long as the ECB and other central banks are at their mercy and respond to every threat the status-quo would remain.

Over the past two years we have seen that surrendering to the demands of the markets does not help in any way. Greece, Spain, and Italy are in as much trouble as they were two years ago. May be its time the governments and central bankers take the risk of making the investors share in the pains of the losses made. Who knows, maybe they will stop taking bets on some of the risky sovereign debts and a solution might be found. The recent announcement by Bernanke was a great start. Now the ECB and European governments need to follow suit.

Comments

None can doubt the vercatiy of this article.

Great post, Dan. I agree 100% about the need for improved shread awareness in policy communities about the risk of a cascading failure on the ground triggered by any one of the drivers you cite.One point I'm curious about are there any instances in which we can demonstrate real success in conflict prevention not so much preventive deployments a la Montenegro, but successfully tackling underlying drivers before they flare up? I realise that in a sense this is an impossible question since it relies on a counterfactual, but I think that advocacy in this area would be easier if we were all able to point to some good examples of what we're talking about working in practice.

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