Slaves of the markets
New evidence on what drives central banks to decide to change rates
CENTRAL banks are supposed to target inflation and in some cases, economic growth or full employment. As the “lender of last resort”, they also have responsibility for safeguarding the financial system. But do they in fact target asset prices as well?
That has been the suspicion from the late 1980s onwards, when the Federal Reserve began cutting interest rates when equity markets wobbled. This approach became known as the “Greenspan put” (Alan Greenspan was the chairman of the Fed from 1987 to 2006, and the put option is a form of insurance against falling prices). The implicit guarantee from central banks became a bit more explicit in the era of quantitative easing (QE)—the creation of new money to buy assets. Central banks hoped that QE would have a “portfolio rebalancing effect”, with investors being forced out of low-yielding government bonds and into corporate debt and equities.
However, the relationship between market movements and central banks may have an even longer history. That is the implication of new research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School for the latest Global Investment Returns Yearbook, published by Credit Suisse. They looked at the historical relationship between movements in interest rates and in financial markets, with particular reference to America and Britain.
Unsurprisingly, they found that markets performed much better when rates were falling than when they were rising. Since 1913 (when the Fed was founded) American equities have returned an average of 9.3% a year in real terms during easing cycles, defined as the period between the first cut and the first increase. In contast, real returns during tightening cycles were just 2.3% a year.
Government bonds returned 3.6% during easing cycles and 0.3% in tightening ones.
This rule applied in most of the 21 countries covered by the trio’s data, going back to 1900. On average, equities earned 8.4 percentage points more in real terms in the year after a rate cut than in one following an increase. Alternative assets such as houses, art and gold also did better when rates were falling.
That is how the markets reacted to central banks. Perhaps the more interesting finding is how central banks have responded to the markets. The chart shows the changes in volatility for equity and bond markets before and at the time of rate increases and rate cuts. Although stockmarkets (and the British bond market) were a lot more volatile after a rate rise, there was little sign of increased volatility before a rise.
In contrast, both the British and American stockmarkets were almost as volatile before a rate cut as after one. The academics suggest central banks are following a rough rule of thumb.
They postpone rate increases when volatility is high, for fear of causing further upset, but respond to high volatility with rate reductions.
Investors may thus have learned that if they throw the equivalent of a toddler’s tantrum, central banks will eventually come to their rescue. Over the long run this might have encouraged risky behaviour of the kind that was common in the run-up to the crisis of 2007-08.
The power of tantrums may still apply. In September the Fed postponed a rate increase in part because markets seemed to point to a slowdown in the global economy. The latest turmoil—the Vix measure of stockmarket volatility has risen from 15 to 26.5 over the past three months—may have induced another bout of caution. Before the start of the year the markets expected several rate increases in 2016; now there is a marginal consensus in favour of unchanged rates. This week’s comments by Janet Yellen, the Fed’s current chairman, to Congress about less supportive financial conditions will bolster that view.
Whether central banks should be so sensitive to the whims of financial markets is another matter. There are wealth effects that reverberate in the broader economy when asset prices fall, although housing (where prices are still rising on both sides of the Atlantic) has more impact than equities.
And market turmoil may be an indicator of trouble in the global economy: figures out this week showed sharp falls in British, French, German and Italian industrial production in December. Then again, central banks ought to be able to work out the economic outlook on their own.