Comforting Implicit Policy and the Yellen Put

Christophe Donay writes in the FT:

The considerable dislocations in financial markets at present are rooted in policy decisions by central banks. Since 2009, all the major central banks have switched from inflation targeting to forms of quantitative easing and zero interest rate policy.In practice, this has involved asset price targeting. Not as a formal policy style — in any case the necessary academic framework for a fully-fledged asset price targeting regime is not yet ready — but in terms of de facto seeking a wealth effect. For example, when the Federal Reserve launched QE, it explicitly targeted reflating prices of equities and related assets and pushing down short and long-term interest rates, in order to stimulate economic recovery.

However, what has implicitly been practised can in fact be described as asymmetric asset price targeting. Whereas pure asset price targeting would involve a floor and a cap on asset prices (in order to avoid boom and bust cycles), central bank QE, by contrast, just puts in a floor.

As central banks, led by the Fed, end QE and zero rates, asymmetric asset price targeting is emerging as the implicit new policy style. Implicit, in that this is not a policy style formally announced by central banks. And asymmetric, in that it continues to involve a floor but not a cap for asset prices. The targets are broadly unchanged: maintaining a wealth effect, keeping down financing costs, expanding the credit cycle, and hence boosting lacklustre economic growth.

However, just as this new policy style is emerging, so are the unintended consequences of monetary stimulus. Considerable research over the past 15 years has suggested that loosening monetary policy has a strong tendency to inflate asset prices and move economies away from equilibrium. And this is indeed the environment that prevails at present.

I agree with his conclusion that the emerging new style of central bank monetary policy offers considerable comfort for investors. On top of this, we have a very benign inflation backdrop thanks to a slowing Chinese economy – space that central banks would undoubtedly use to keep the markets happy.

The Fed with its dual mandate has an extra incentive to support all asset markets given a wealth effect of between 4% (Shiller et al, 2005) and 5% (Carroll and Zhou, 2011).

I can’t say whether this will end well or not, but a crucial question comes to mind: are we underpricing the true risk yet again, or have we learnt our lesson this time that even the most powerful central banks can’t underwrite every market?


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