Central Banks Didn’t Eat Your Lunch

One of the consistent trends you’ll find in my econ and finance work is that I don’t think much about Central Banks. In other words, I think mainstream macro puts far too much emphasis on the efficacy of things that Central Bankers do.  This is why I said QE wouldn’t do much back in 2009 and it’s also why I’ve consistently argued that the Federal Reserve wasn’t the primary cause of the stock bull market of recent years.

Of course, none of this means Central Banks have no impact at all.  That would be wholly naive.  I know that Central Banks have powerful policy levers and can influence the economy in significant ways.  But I think mainstream macroeconomists, policymakers and laypeople tend to put far too much emphasis on the impact of these tools.

To highlight this point I want you to think of the global economy like a gigantic lake.  When the Federal Reserve does something like change interest rates or implement QE it is analogous to the Central Bank dropping a stone in the middle of this lake.  The ripple caused by this stone will be seen across the entirety of the lake, however, this does not mean that the lake was impacted evenly or even that it was impacted significantly.  For instance, when the Fed changes the overnight rate it has an absolute impact on the rate at which banks lend overnight.  However, as you move out on the curve the impact is increasingly muted.  We’ve clearly seen this in recent weeks as the long bond yield has fallen since the Fed first increased rates.

The same analogy can be used across the entirety of the economy and the financial markets.  Regarding stock prices I would argue and have argued that the Fed’s policies have only an indirect and highly imprecise impact on stocks.  There are forces much more significant impacting the direction of stock prices than Federal Reserve policy.  For instance, arguing that something like QE drives stock prices is as irrational as arguing that a stock buyback impacts stock prices more than the firm’s underlying operational output.  While stock buybacks and QE are not impactless, we should not confuse the cart for the horse.  Of course, this just means stock prices were impacted less than other instruments such as short-term bonds and other financial assets.  It does not mean QE had no impact on all financial assets.

I think we put far too much emphasis on the impact of Central Banks in the global economy.  This leads us to believe that financial market booms and busts are caused directly by Central Bank policies and it also leads us to believe that Central Bank economic policies are much more powerful than they really are. Unfortunately, all of this focus on Central Banks has resulted in a view of the world that is far more ideological and narrow minded than the reality in which we reside.  As a result, we have been excessively focused on a stone falling in a lake all the while missing the evaporation of the lake thanks to outside forces.