Watching the Monetary Politbureau

The Age of Kremlinology

Ben Bernanke, chief of the monetary politbureau, praying for his theories to work.

By Pater Tenebrarum

As long time readers know, we have often compared the parsing of the statements issued by the Federal Reserve to the now defunct job of 'Kremlinology'. This was a quite similar exercise during the cold war era, when knowledgeable journalists and observers of geopolitics used to parse every phrase emanating from the Moscow politbureau in the Kremlin to discover the hidden meaning in its often obscure statements.

Were reformers gaining ground? Was the old guard getting ready to alter course? Were the hawks or the doves prevailing? These seemed all highly important questions in an age of 'mutually assured destruction', with tens of thousands of nuclear armed warheads ready to rub out civilization at the push of a button.

In the US, the CIA's wildly inflated assessments of the Soviet Bloc's military and economic capabilities gave birth to such movements as the 'Jackson Democrats' (Henry 'Scoop' Jackson was a committed anti-communist memebr of the Democratic party) and the neo-conservatives, all of which were in favor of expanding the military-industrial complex in order to counter the Soviet threat.

To this day the myth prevails that Reagan brought the communist bloc to its knees by outspending it  on military hardware. In reality, the CIA's assessment of the Soviet Union was utterly misguided -  the entire communist bloc had been de facto bankrupt for  a number of years already. When West German businessmen and economists finally had the chance to examine the books of the enterprises of East Germany – then held to be the economically by far strongest member state of the COMECON  – they were in for the shock of their lives. What had for decades masqueraded as the economic 'success story' of the communist bloc turned out to be in a state that can be best described as 'beyond bankruptcy'.

Today the Federal Reserve and other major central banks are to the financial markets what the Kremlin used to be for the world at large: their actions and statements are considered of the utmost importance to the trends in financial asset prices. Any slight change in the wording of an FOMC statement tends to lead to huge volatility in financial markets. The manipulation of these markets by central banks has become the by far most important factor in 'macro' analysis today.

This has given rise to a new version of 'Kremlinology' – today, all the utterances of the monetary bureaucrats are parsed like those of the aging Kremlin autocrats of yore.

Of course, underlying it all is a fallacy quite similar to the one that was evident during the cold war, namely the 'potent directors' fallacy. It is widely held that the Fed and other central banks effectively 'control' the markets. This is a grave and potentially very costly misconception.

Mind, we are not trying to deny that central bank policy is in fact the most important fundamental factor moving financial markets nowadays. This can be seen inter alia in the vast increase in intra-market correlations, which has made stock picking a nigh fruitless endeavor. Today the component stocks of the S&P 500 index are more strongly correlated than even during the most memorable market crashes of the past century.

What we are saying is merely: the idea that the central banks influence the markets is perfectly correct. Alas, the idea that they therefore actually 'control' market outcomes is mistaken.

Bob Prechter would probably say that 'unless the social mood is in a positive trend, central bank intervention can not produce an up trend in stock prices'. We by and large agree with this as it were – in order for monetary pumping to seemingly 'work', the public's perceptions must be such that it is prepared to at least temporarily fall for the illusion of prosperity money printing provides  – usuallyagainst its better judgment.

However, as we have also frequently pointed out, there is no ironclad law that says that an increase in free liquidity must lead to higher stock prices. It often does have that effect in the short to medium term, but this depends not only on the public's mood, it also depends on the state of the economy's pool of real funding. A stagnating or declining pool of real funding makes it impossible for resources to be diverted into 'bubble activities'. In that case it doesn't matter how much money the central banks print: there will be nothing left to lend and stock prices may well end up declining in spite of their ministrations, as investors rather opt for the 'safe havens' of government bonds and gold.

In the context of modern-day Kremlinology, we noticed a recent article in the WSJ that makes for a quite funny read. It is entitled “A Few Head Scratchers In Some Fed Statements” and discusses the semantic problems created by the Fed's utterances in some detail.

The job of today's Kremlinologists is not easy as you will see. Apparently the Fed's desire to 'improve transparency and communication' is still failing. The following excerpt contains a number of knee-slappers as it were.

“Documents released by the Federal Reserve this week left Fed watchers struggling to divine the difference between phrases like “a few” and “a number.”

It’s the type of head-scratching the central bank’s carefully-crafted statements and minutes have long produced and continue to generate, despite the Fed’s recent push to communicate more clearly.

Economists parsing the “summary of economic projections” released Wednesday along with the minutes of the Fed’s Jan. 24-25 policy meeting puzzled over the descriptions of how many Fed officials were prepared to start buying more bonds this year to boost the recovery, compared with how many wanted to wait to see if the economy weakened before taking more action.

“A few participants’ assessments of appropriate monetary policy incorporated additional purchases…,” the minutes said, while “a number of participants indicated that they remained open to a consideration of additional asset purchases if the economic outlook deteriorated.”

Several Fed watchers thought “a few” translated into a smaller group of officials than “a number.”

“In Fedspeak, ‘a number’ is greater than ‘a few,’” said Dean Maki, chief U.S. economist at Barclays Capital, who previously worked as a researcher at the Fed. A “few” probably means in the range of three officials, while “a number” is more in the ballpark of five, he said. “There clearly was information being transmitted in those two different phrases,” he said: fewer Fed officials think another round of bond-buying would be needed soon.

While there’s no official manual, Maki said he would rank the Fed’s descriptions of group size as, in ascending order: “few,” “some,” “a number,” “many,” “most,” and finally, “all.”

Deciphering the Fed’s language is a skill acquired over time, he said. “I don’t think there are short cuts.”

(emphasis added)

See, you have to carefully differentiate between “few,” “some,” “a number,” “many,” “most,” and finally, “all.” :)

More from the WSJ article:

“Economists say every word issued by the Fed can help them understand how the central bank views the current state of the economy and how it might be plotting its next move.

“People want to squeeze out every last drop of nuance and meaning from the minutes,” saidMichael Feroli, chief U.S. economist at J.P. Morgan Chase. While the Fed’s language can be tricky to translate, “if you follow it long enough, it becomes a second language,” he said.

Another source of mystery are the words “exceptionally low” in the Fed’s policy statement released after meetings. The central bank has been signaling since March 2009 that interest rates would stay at “exceptionally low” levels for a long time.

How low is exceptionally low? Economists are struggling to understand. In an August speech in Jackson Hole, Fed Chairman Ben Bernanke said it meant at “current low levels,” which are near zero. But some economists took comments he made in a January press conference to imply it could mean up to 1%. The minutes didn’t clarify the confusion.

Analysts also debate the degree of difference between the words “moderate” and “modest.” The Fed uses both to describe the pace of economic growth, but economists don’t always know which one reflects a cheerier outlook.

“All those adjectives,” sighed Philip Suttle, chief economist at the Institute of International Finance, the global association of financial institutions. “You can tell ‘slight’ versus ‘severe’ — there’s a nice difference there, but some of the stuff in the middle is harder to tease out.”

Maki felt confident he could draw a thin distinction. “I do think there’s a slight difference where ‘moderate’ is a bit stronger than ‘modest,’” he said.”

(emphasis added)

The really funny thing is, none of it actually matters in the end. Who cares what the 'economic outlook' of the bureaucrats is?  They have been so consistently and utterly wrong about every single major economic turning point over the institution's entire history (check e.g. the minutes from Fed meetings in the 1930's and 1970's – these guys have alwaysbeen clueless, it is not a recent phenomenon), that we can at best use their assessment of the economy's prospects as a contrary indicator.

It is of course important to be aware what their next policy steps will be, if only to be prepared for the likely short term effects on the markets and the economy. Alas, one should always keep in mind: nothing they do can alter the market's primary trend. They will always err on the side of too easy money, the main effect of which is to make the amplitude of the business cycle far greater than it otherwise would be. It means we are experiencing more lengthy, but also far more volatile business cycles. Rallies in 'risk' assets may be magnified, but so are the subsequent crashes.

As we have often pointed out: if the central bank truly 'controlled' the markets and the economy, there would never have been a crash and recession in the first place. The widespread faith in the power of these bureaucrats – which they themselves arrogantly share – continues to be quite misplaced.