Central banks and the certain uncertainty paradox

Alan Greenspan quote
Former Fed Chairman Alan Greenspan on the outlook for the US housing market, October 2006

“Uncertainty is an uncomfortable position. But certainty is an absurd one.” – Voltaire

US Federal Reserve Chair Janet Yellen lifted markets midweek by pouring cold water on recent comments from a number of regional US Federal Reserve Presidents. In a speech at the Economic Club of New York – entitled “The Outlook, Uncertainty, and Monetary Policy” – Yellen took the opportunity to “explain why the Committee anticipates that only gradual increases in the federal funds rate are likely to be warranted in coming years”.

While equity markets reacted positively to Janet Yellen putting her colleagues back in their hawkish box on the possibility of early rate hikes, it may also be worth considering the source of her dovishness. Her first concern relates to “the pace of global growth”, with emphasis on the influence of China and how smoothly they will be able transition “away from investment toward consumption and from exports toward domestic sources of growth”. Yellen’s second concern raised in her speech is around “the prospects for commodity prices, particularly oil”, with further declines potentially forcing increased layoffs and cutbacks in government spending in oil producing countries.

These are risks that everyone is aware of, and which have weighed on equity markets in the last quarter. However, correctly predicting ahead of time whether or not these risks will manifest into something more serious is the real challenge. So far, the major central banks have been able to avert a more meaningful correction in equity markets. Still, if we look at the yields on core government bonds they do not paint a rosy outlook for the global economy and its emergence from the post crisis malaise. Unless governments can address the impediments to global demand, it is hard to see equity markets delivering the returns of the last five years in the next five, particularly as the impact of monetary policy eventually wanes.

The other consideration is that while Investors continue to look to central banks for guidance, it is important to remember that these institutions are no more certain than anyone else about how economic conditions will unfold. Their statements are always laced with caveats on their forecasting ability, yet markets obsess over every detail as if they have some inside knowledge on how the economy will evolve. They don’t. Of course, what makes this dynamic even more interesting is that central banks are seeking to influence how economic conditions evolve based on how they perceive them at a point in time. Yet that perception may not always be the reality, as we saw in the lead up to the global financial crisis.

The Fed’s current baseline scenario is for rates to rise gradually as economic headwinds fade. In her speech Janet Yellen included this caveat: “Implicitly, this expectation of fading headwinds and a rising neutral rate is a key reason for the FOMC’s assessment that gradual increases in the federal funds rate over time will likely be appropriate. That said, this assessment is only a forecast. The future path of the federal funds rate is necessarily uncertain because economic activity and inflation will likely evolve in unexpected ways. For example, no one can be certain about the pace at which economic headwinds will fade. More generally, the economy will inevitably be buffeted by shocks that cannot be foreseen.”

Yellen tempered this admission of uncertainty with a more certain commitment, something markets love: “What is certain, however, is that the Committee will respond to changes in the outlook as needed to achieve its dual mandate.” However, in reality what is even more uncertain is whether their certain response is the right one!

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