Keep ’em Guessing, Like in the Old Days

February 4, 2014

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Our key central banks are fostering moral hazard in markets. Your report “Yellen left with the challenge of guidance tactics” (January 27) noted that ways to “toughen” guidance “all revolve around a more precise description of economic conditions in which the Fed would not raise rates.” In other words, new Fed chairwoman Janet Yellen should more explicitly comfort markets.

On your front page on the same day you report on European Central Bank president Mario Draghi’s suggestion that the ECB could buy securitised eurozone bank loans to households and companies if such asset-backed securities were “easy to understand, price, trade and rate.” Your report concluded, correctly, that this new euro asset class could “spur the financial sector into creating a market for such assets in anticipation of potential vast profits if the ECB were to become a large purchaser.”

Such Fed and ECB policies aim to reassure financial market participants rather than keeping them guessing. In the “good old days,” before quantitative easing, forward guidance and zero real interest rates, investors, asset managers, traders and bankers were forced to make difficult but educated guesses about the opportunities and vulnerabilities in financial markets. The danger of making a bad guess was, and should remain, an important restraint on excesses and systemic risk.

Today’s market participants are babied with excessively explicit “forward guidance,” supported by historically low interest rates and yields (especially in real terms) and central bank purchases of securities if markets weaken. Such a “safety net” makes investors and traders so complacent they panic at any hint of normalised yield curves and real interest rates, as occurred in bond markets when chairman Ben Bernanke dared mention “tapering” in May 2013 and today’s downturn in emerging markets.

Fed and ECB support for such “one-way” thinking promotes excessive complexity, new financial bubbles, too-big-to-fail financial institutions and systemic risk, as well as economic-social consequence. QE and forward guidance have done little to promote sounder economic growth and job creation.

The huge cash positions of US and European companies, sluggish capital spending growth, declining labor market participation rates and increasingly overpriced financial markets are symptomatic of the moral hazards being promoted by central banks. Ms. Yellen and Mr. Draghi should make market participants earn their (high) pay.


This letter was originally published in the Financial Times (available at and is reposted here with permission of the author.

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