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Central Bank Credibility Wanes

blog | Published On 9/21/2015 12:34:29 PM by Everett Millman

It's difficult to say whether or not the world's central banks are unaware of the damage they are doing to their reputations, or if they simply don't care.

yellen2 Image source: CBC

For several years now, the world economy has been held in a state of perpetual emergency, with monetary authorities (i.e. national banks or central banks) from each corner of the developed world relying heavily upon unconventional stimulus measures to boost their stagnant economies.

No matter how it is reported (spun) in the media, there is no definitive answer on what we can expect from these monetary easing policies in the long-run. So why should we trust central banks like the Fed when even they can't explain how quantitative easing (QE) is supposed to affect markets?

Extreme Policy

The implementation of QE was supposed to be an inflationary event (meaning it would generate inflation) by pumping the economy with extra liquidity—easy access to cash and financing. Yet, even a year after the Federal Reserve ended its QE purchases, inflation in the U.S. is still running just a shade above zero. Inflation has likewise been virtually nonexistent in Europe and Asia, where the European Central Bank, Bank of Japan, and People's Bank of China have all continued to engage in more stimulus through rate cuts and growing their balance sheets.

raining-euros-from-skyFor reference, the Federal Reserve's balance sheet has grown from below $1 trillion to $4.5 trillion in the period since the 2008 financial crisis. Similarly, the ECB is on track to see the assets on its books balloon by more than €720 billion (more than $800 billion) by 2016. ECB President Mario Draghi has also been adamant that he's willing to do more—"whatever it takes"—to support the euro and keep the Eurozone intact.

The bald truth is that each of these central banks are venturing into uncharted territory, even if they believe they're somehow safer in doing so simultaneously.

Hard to Trust

Not only has the monthly melodrama of "To Hike Or Not to Hike?" taken its toll on market participants who no longer believe the Fed when it says economic conditions are improving. If that's truly the case, why haven't they raised rates yet, then? The connection between credibility and raising rates lies in the Fed's promise to begin normalizing policy when it looked as though the economy had sustainably emerged from recession. Each month that the FOMC decides it's too soon the raise rates, the markets get another signal that the economy is not doing well enough yet to be taken off of "emergency aid" status.

yellen3 Image source: Business Insider

The problem is that the Fed keeps touting how the economy is moving toward its key targets—except on inflation, the one thing that QE was supposed to help boost.

With rates already near-zero, there's nowhere further down to go; in other words, these central banks have run out of room in terms of making money any easier to obtain—short of using negative interest rates, an almost-unheard-of policy that we have begun to see in Europe. Unless the Fed intends to follow suit, the central bank is basically admitting that its tools of accommodation (like rate cuts and liquidity injections) no longer have any potency. In the words of Bloomberg, the punchbowl is empty.

Bullard vs. Cramer?

cramerThe notion that the Fed is losing credibility is evidenced, in part, by the media questioning the bank's logic. For instance, Mad Money host Jim Cramer recently fired back at St. Louis Fed President James Bullard for suggesting that Cramer "cheer-leads" for stocks to go up, advocating for the Fed keeping rates artificially low for even longer. Oddly enough, Cramer's point that the economy isn't doing that well yet (and thus isn't ready for a rate hike) has the contradictory effect of showing that QE and ZIRP had very little results in the real economy, and merely helped keep Wall St happy.

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