Friday, February 12, 2010 10 comments ++[ CLICK TO COMMENT ]++

Central banks lag the market

A couple of days ago, Phil, a reader of this blog, left a comment challenging my view that a "central bank has far less control of the economy" than many assume. I want to present a view that is completely radical that it may alter your thinking. This blog might be the worst investment blog known to man ;) but hopefully I make you think (but do note that I can be wrong.) I didn't come up with the idea I'm about to present (I'm just repeating others' views) but it completely changed my thinking a few years ago. In fact, it altered my view so much that, these days, I don't believe a central bank can "save" an economy no more than it can "boost" the economy (in the long run.) None of this is to say the central bank is useless—indeed, it plays a very powerful role, as many Keynesians would suggest, when it acts as a lender of last resort (usually during wars or economic calamities)—but the vast majority of the time a central bank really doesn't control much.

Before I present the view, I should make some exceptions. Central banks are very powerful under totalitarian regimes. So none of this applies to them. In addition, what follows probably doesn't apply to central banks that do not follow "modern" (developed-world) economics or are based on some "primitive" economic systems. For instance, I am sure that none of what I say applies to the central bank of Afghanistan (assuming it even exists.)

The Federal Reserve You Never Knew

Probably almost everyone reading this probably assumes that the a central bank, like the Federal Reserve in America, controls the short-term interest rate. Many would have grown up thinking that the central bank directs the economy. I'm going to present some information that challenges that view.

In article challenging the influence of the Federal Reserve—a highly recommended read for those who are macro-oriented—John Hussman had this to say:

(Note: The bolds in the quote are by me; Hussman's original comments also contains bolds but they are not reproduced here. If you do read the full piece, keep in mind that my post is dealing with a narrow topic, short-term rates, whereas Hussman's article is talking about the FedRes in general.)

The main job of the Federal Reserve is to determine the mix of government liabilities held by the public. When the Fed "eases monetary policy" or "cuts interest rates", it accomplishes this as follows. The Fed goes into the open market, buys a bunch of Treasury securities from banks (who have drawers full of them), and pays for them by creating new bank reserves.


When the Fed "cuts interest rates", what it is really doing is replacing one government liability held by the public - Treasury securities - with another government liability: currency and bank reserves (monetary base). That's all the Fed does. It determines the mix - but not the total amount – of government liabilities held by the public. Since the operations of the Fed are executed by buying or selling securities on the open market, the group at the Fed responsible for these decisions is called the Federal Open Market Committee, or FOMC.


Essentially, the Fed lowers the Federal Funds rate by purchasing Treasuries from banks and increasing the "monetary base" - bank reserves plus currency in circulation. The only thing that the Fed can control with certainty is the monetary base. Alternately, it can try to control the Federal Funds rate (and passively adjust the monetary base by whatever amount is required to keep Fed Funds on target). However, the Fed cannot control the Federal Funds rate with certainty. For example, if inflationary pressures were high and interest rates were moving up, the Fed could not predictably lower the Fed Funds rate by easing monetary policy. Not surprisingly, central banks always target money growth, not interest rates, when inflation is high. That's why Volcker targeted money supply, while Greenspan targets interest rates. But ultimately, the only thing that the Fed can directly control is the monetary base.


Except for the Federal Funds rate, the Fed does not determine short-term interest rates. Most of the time, it simply follows them. Statistically, the Federal Funds rate consistently lags market interest rates such as Treasury bill yields. Indeed, changes in market rates have far more predictive power to forecast the Federal Funds rate than vice versa.

The main exception is the Prime Rate. Changes in the Prime Rate follow changes in the Federal Funds rate largely because 1) competition forces equality of lending rates; 2) the Fed Funds rate tracks other short term rates, and; 3) changing Prime in unison at any other time than a discrete Fed move would be considered evidence of collusion among banks.

Admittedly, economics is the dismal science and some may dismiss John Hussman's views as being too outside-the-box thinking and possibly erroneous. But before you dismiss his views, at least think about them.

John Hussman says that the Fed Funds Rate, which is the only short-term rate the FedRes controls, lags the market rates. Is this really true? I was shocked the first time I saw a chart like the following (chart courtesy Robert Folsom of

I'm too lazy to look up a chart that is more recent (this one only goes up to early-2008) but it doesn't alter the main point. Notice how the fed funds rate follow the T-bill rate. The T-bill yield is set by the market while the Fed Funds rate is set by the FedRes. This isn't one fluky year or something; it's almost a full decade of data points. The Fed Funds rate has consistently lagged the t-bill yield.

The same picture is also true in the longer run. The following chart by Tim Wood apparently illustrates it (admittedly it is very hard to see from the picture):

It's really hard to see from that chart but you just need to believe me when I say the Fed Funds rate follow the market-controlled t-bill yield—either that or you need to go and do your homework. If you drilled into a narrower time frame in the chart above, you'll essentially get a chart like the first one, with the Fed Funds rate following the t-bill yield. It's not always perfect and things like wars may alter the relationship somewhat but, in the grand scheme of things, the FedRes rate lags the market.

What Happens If the FedRes Raises Rates to 12%?

Phil rhetorically asked what happens if the FedRes jacks up the shot-term rates to 12%.

In the short term, anything can happen. I wouldn't debate anyone's view that the cost of debt, for instance, would be really high initially.

In the long run though, my view is that it would not contract (or cool) the economy as much as many would assume (the actual result depends on a whole hoard of other factors.) I'm not an economist or a financial expert but my guess is that, if the market rate was lower, the free market would bypass the central bank. Borrowers may borrow in foreign lands at lower rates; or lenders may charge lower rates even though the FedRes is keeping rates high. If you want to see how this can happen, consider the opposite case.

What happens if the central bank sets rates really low while the market prices it much higher? Well, we just need to look around because this scenario is pretty common (governments don't mind setting rates low but don't like high rates (the original scenario above.)) There are many countries, usually in the middle of a crisis, who do that. I have to double-check the numbers but I believe Argentina in the early 2000's, Brazil in the 90's, Zimbabwe in the late 2000's, among numerous others, have done that.

In the very extreme case of Zimbabwe, you had the central bank essentially dictating a really low rate while the free market was pricing in very high rates. In practical terms, this basically meant that the government would loan you money at fairly low rates while private investors demanded very high rates (no one would be caught dead loaning money at low rates while the hyperinflation beast is running all around your neighbourhood.) In the end, the economy ended up, in some sense, bypassing the central bank. What the central bank did had little influence. No private citizen or business would freely loan you money at low rates even though the central bank was trying to maintain a low rate (countries like Zimbabwe heavily regulate, usually be arbitrary jailings, beatings, and stealing (taxes) so what I am saying may not be the public view of the lenders i.e. no one would freely lend you money at low rates but some would have because of government threats.) In any case, the point here is that the central bank had very little control even though it was a democratically-elected totalitarian government with greater control than USA.

I believe a similar thing, with the market bypassing the central bank, would materialize in the original scenario of 12% rates. I don't have any proof of it but I do think the central bank would lose even more power if it priced its rate at a high level while the market prices it much lower.

How About Long-Term Rates?

So far we have dealt with the interest rate that is generally under the most direct control of a central bank: the short-term rate. How about the long-term rate?

Well, again, I'm not an economist but I don't think the central bank has much influence over long-term rates either.

First of all, they generally have even less control over the long-term rate. At least the central bank "sets" the short-term rate whereas the long-term rate is generally under the control of the market (essentially bond buyers.)

The only way the central bank controls the long-term rate is to go out and buy (or sell) government bonds. This generally involves printing money and buying long-term government bonds with that money (it's called monetization and, all else being equal, results in inflation.) Outside of some crazy scenarios (usually involving war) central banks can only influence, indirectly, the long-term rates. Even then, the rates don't move much because the long-term debt obligations are very large and you need to spend hundreads of billions (or possibly trillions over a period of time) to do much.

So, I don't believe the central banks control the long-term rates so they aren't very powerful on that front either. However, if they do manage to control the long-term rates, they will be really powerful. At times, they have done that (usually during wars (eg. America during WWII) or when acting as lender of last resort (eg. when no one wants to lend money (like in the last 2 years)) but those don't last.

Final Word

So to sum up, central banks aren't as powerful as they appear. Their most direct control is the short-term interest rate but even with that, they generally follow the market rate. I think a lot of people probably think a central bank is powerful because their daily dealings revolve around the prime rate, which essentially follows the Fed Funds rate (as John Hussman pointed out above.) If you buy a home or a car, it is driven primarily by the prime rate so I can see why people think central banks are powerful. After all, when the FedRes cuts rates, the prime rate drops almost instantly and people think the central bank has a lot of power.

The way I look at it, central banks are weak most of the time. However, their power is inversely correlated—yes, I made that up but believe it's true—to the severity of a crisis. The worse an economic crisis is, the more powerful central banks are. This is mainly because of their ability to act as a lender of last resort, ability to print money at will, and the legal power to heavily regulate financial institutions and (in some cases) capital market transactions.

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10 Response to Central banks lag the market

February 13, 2010 at 6:00 AM

Very interesting, especially because Hussman is one of my heroes, together with Grantham and Klarman. And speaking of Grantham, he often writes about the Fed effect on the 3rd year of the presidential cycle, where lax monetary policy eases the way for reelection. And he is adamant in this effect being monetary, not so much fiscal. I cannot see how these two lines of thought can be combined. But I would definitely like to have them reconclled.

February 13, 2010 at 9:16 AM

You certainly picked 3 heavyweights as your heroes... can't go wrong with any of those three 8-) , although they are three completely different investors so I'm not sure how you use their knowledge. For instance, I can see Seth Klarman saying everything John Hussman worries about (macroeconomic stuff) is a complete waste of time.

Anyway, Jeremy Grantham keeps referring to the presidential cycle but I am not a believer in it. It sounds too much like a religious belief rather than a scientific fact. Grantham relies on historical data but without a solid theory to explain it all, it sounds like a belief. It has worked in the past but, the justification is kind of flaky. For example, didn't it fail in the current cycle? I don't follow that cycle but I believe the huge stock market rally of 2009 is not consistent with the cycle (or something like that.) In fact, it is likely that the rally of 2009 will be much stronger than any potential rally in the upcoming (or past) 3rd year--or any other future rally.

February 13, 2010 at 8:30 PM

I mostly agree. Although to me it seems this is mostly a matter of central banks being unwilling to practice truly radical policies. They would be much more powerful if they were not run by such extremely cautious types.

Zimbabwe does not seem a good example of central bank power. In Zimbabwe Mugabe first completely destroyed the economy by expropriating most business and handing it to incompetent cronies. When tax revenue, predictably, collapsed he filled the hole with printed money, with equally predictable results.

Meanwhile, everybody seems to be waiting for the Greek bailout. I´m guessing it will not happen...

February 14, 2010 at 1:06 PM

I don't know what a Greek bailout entails. They have fiscal budget problems and the government voted down some tough measures. Even if the EU provides more funding, I have a feeling the problem will still exist.

The other issue with Greece is that any bailout would set a precedent. It's not just Greece that is facing a problem; we also have Spain and Ireland with difficulties, and possibly others that are borderline, so it would be difficult to just do something with Greece while ignoring the others. To me, it's a multi-country crisis and that makes it difficult to solve.

February 15, 2010 at 5:43 AM

I read Hussman's comments every week.

I must admit, however, that when the subject turns to high finance, liquidity, money supply, the Fed, and so on, I struggle just to keep up, and have no firmly stated opinions of my own.  I'd like to understand better, but I'm not sure how much it would help my investing even if I were an expert.

February 15, 2010 at 3:23 PM

The more you lean towards value investing, the less the macro stuff matters. In fact, the macro stuff can be very detrimental to one's investing if they are strictly a value investor. I'm macro-oriented so I tend to pay attention but others who are pure fundamental investors should avoid getting entangled in macro information.

I read Hussman on and off, but I tend to be more interested in his investment analysis more so than his economic analysis. For instance, I like reading his (or his analysts') articles on how, say, returns are correlated (or not correlated) with P/E ratios; or stuff like that. Him, and his team, have published insightful reports that are freely available (I should link to those more in the future I guess.)

As a newbie and a non-expert, I feel that the more "economic" an issue gets, the less actionable it is as an investment. I think you share the same view.

February 17, 2010 at 1:18 AM

Most central bankers are put in their positions by the democratically elected governments.  And democratically elected govts are, by definition, populist.  As populists, they are undesciplined (an extension of the madness of crowds) and will therefore always deflate the value of the currency over time (in lieu of curtailing spending...access to the proverbial punch bowl).  This will make their govt debt, which results from lack of discipline in fiscal spending, easier to pay off.  This is true over time for most governments (with only relative exceptions, like Germany, in recent times.  Note that this fiscal conservatism is, what I believe, a cultural trait - ergo the PIGS v the lutherans, etc.)

If you control the balance sheet - i.e. the currency, you have, by definition, a great amount of power over interest rates.  This recent acts of the Fed - grossly inflating their balance sheets to bond investors, proves this.  They had a choice to let the 'laissez faire' (the market) dictate the results, but preferred to bail out the rich (again, bond investors).  By bailing out bond investors, they signaled that they wanted to borrow more.  Had they chosen to follow the path of fiscal discipline (i.e. cut spending...austerity...etc), they would have chosen to let banks default.  They kicked the can down the road (extend and pretend).

I agree that ST interest rate moves, in normal times, via the Fed funds rate, are signaling moves.  And they therefore affect ST bond rates (3 month Tbill rates).  And in normal times and in the short run, the scenario you described, probably plays out.  But when you get to the end of you ability to borrow/spend, things changed (ask an American homeowner...).

February 17, 2010 at 1:18 AM

In the long run, ST interest rate policy affects the economy via the banks - who borrow short and lend long.  Interest rate policy therefore has a very strong effect on the economy.  Leave rates too low  and long term assets (housing) inflates in price due to affordability for the masses via low ST rates. 

The tipping point in the recent credit crisis was caused by a relatively small increase in ST rates at the end of a period when they were kept too low for too long (due to Greenspan's lack of talent as a central banker - though perceived as a good central banker by the elected populists who put him in power).  See Bill Gross's very timely article called 'Ten Little Indians' in 2007 (if I remember correctly) which shows the domino effect of rises in interest rates (especially at the end of a period of time when the central banker has not used his interest rate increase tool for too long a period to stem inflation).

The above is why an 'inverted yield curve' predicts recessions with 80% effectiveness (I bet this is higher when you look at a country's abiilty to borrow...i.e. stimulate and avoid the recession... at the point of inversion...but you need a strong balance sheet for that).  That saved me beaucoup bucks over the past 3 years...

ST rates matter - and when your central banker has a childhood Ayn Rand perversion - bad things happen over the long run.

I would suggest you follow the price of non-cash commodities in the local currency to see if your local central banker is effective controling prices.  Of course, given that it's a big multi-variable equation, the results are only seen at extremes (long periods of time and high debt to GDP ratio).

Canada saw this in the 80s after their drunken sailor named Trudeau ran up huge debt and Canada saw a 'lost decade' in the 80s to early 90s.

Bernanke, currently central banker of both the US and Zimbabwe, is having a better effect on Zim these days as Zim can't get a loan from anyone (since it's lost its balance sheet/currency).

My take on the current situation....(1)  Inflation will be used as a tool to exit bad times (high debt) in most cases by central bankers and (2) be mindful that high debt from credit bubbles will cause deflation (see Irving Fisher...this is another discussion).  We're in a case where Bernanke is talking/showing #1 to try to mitigate the negative effects of #2.  He will fail...but he hopes no one will notice.  I'd hate to have his job....

February 17, 2010 at 1:26 AM

edits to my posts...
<span>1  ...grossly inflating their balance sheets to PROTECT bond investors</span>
2  <span>But when you get to the end of you ability to borrow/spend, things change (ask an American homeowner...).</span>
3  Bernanke having a positive effect on Zim since low interest rate (by using US dollar) creates more price stabiliity and therefore easier for market participants to make long term investment decisions.  And you don't have to carry 10 trillion dollars in your wallet to buy bread...
4  #1 in my take was stolen directly from Buffet...

February 17, 2010 at 7:58 PM

Thanks for your lengthy comments. I'll respond to you later if I get a chance (maybe weekend) but here are couple of quick points...

First of all, I'm not a fan of Bill Gross. I'll try to hunt around for the article you are referring to but I sort of gave up on his skills after his poor calls in the mid-2000s. Admittedly that was before the credit bust and I'm not sure what he was saying during that. All I remember is him leaning towards inflation when the real threat ended up being deflation.

"I would suggest you follow the price of non-cash commodities in the local currency to see if your local central banker is effective controling prices. "

The problem with that is that commodities don't capture inflation. Other assets, particularly real estate can be inflated too. The CPI measures in most countries are supposed to capture real estate prices (or some equivalent rent) but I find them sorely lacking. For instance, consider China, which I think may be sitting on huge real estate bubbles (at least in major Eastern cities.) Although we hear of stories of periodic inflation threats, the price index will completely miss the inflation.

"Canada saw this in the 80s after their drunken sailor named Trudeau ran up huge debt and Canada saw a 'lost decade' in the 80s to early 90s.  "

I'm not picking on you because a lot of people say it but the reality is that the 80's was not as bad as many imagine. Even with the nasty 1982 and 1990 recessions, I think Canadian GDP probably came in around 2% real (I don't have the numbers but just eyeing this chart.) I would also argue that the issues in the 80's had little to do with government debt and more to do with the oil crisis (say 1979 to 1981.)

Anyway, I'm not as negative on Ben Bernanke as yourself. I actually think he is one of the top central bankers and am glad that he was overseeing things in the last two years.

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