Practical analysis for investment professionals
27 August 2015

Are Central Banks Losing Control?

With financial markets exhibiting some serious volatility in recent weeks, many are asking if central bankers are losing control. That’s an important question. But if they are losing control, doesn’t that imply that they have control to lose? Do central bankers actually direct the markets? Or are markets themselves the final arbiter of power?

To understand this issue, we asked CFA Institute Financial NewsBrief readers a very fundamental question: “How much do central banks control the markets (in general)?”

Interestingly, respondents’ answers yielded a bifurcated distribution (i.e., two distinct central tendencies). On the one hand, 36% of the 661 respondents indicated that central banks have “limited control.” On the other hand, 33% stated that central banks exhibit “significant control.” About 24% chose the middle option, indicating that central banks have “occasional control,” meaning they can control the markets in some instances but not in others. Very few respondents fell into the more extreme answer choices of “no control” or “complete control,” which came in at 5% and 2%, respectively.


How much do central banks control the markets (in general)?

How much do central banks control the markets (in general)?


One of the very first things we learn in economics is that there are no free lunches: Any choice or action that has a benefit also has a cost. So, central bankers manage monetary policy. This has many observable benefits, ranging from stimulating lending, to elevating asset prices, to spurring exports, etc., but seldom do we define the costs. While shifts in monetary policy are decided by a handful of individuals in very precise and reasonably well-publicized ways, the costs are born by millions, if not billions, of people and these costs are often very diffuse.

But what are the costs? And who pays for them? These two questions must be answered first in order to assess whether and to what degree central banks control the markets.

Monetary policy has many channels through which it works. Lower real interest rates can encourage investment in housing and consumer durables. Exchange rate effects (cheaper currency) can impact exports. Market value effects can stimulate the Tobin’s Q ratio (increased valuations). Higher market values can increase consumption. On the credit side, monetary policy can stimulate an influx of bank deposits, which in turn leads to more lending. In the balance sheet channel, higher stock prices can induce more capital investment. Lower nominal rates can improve cash flow. Unanticipated price increases can stimulate investment. Lastly, greater financial wealth and liquidity can reduce financial distress and increase investment in housing and consumer durables. Or so the textbooks say. And it all creates the sense that if central bankers tweak policy just enough, they can engineer the right amount of consumption, investment, asset prices, or whatever outcome they desire. Is this true?

There is only one single, albeit disconnected, global monetary system. When it comes to monetary policy, no country operates in a complete vacuum independent of the others. In some instances, monetary policy in one nation can have an oversized impact on foreign countries while its domestic effects are more limited (take, for example, the decision by the Swiss National Bank (SNB) to break the Swiss franc’s cap to the euro). In other cases, the costs are born primarily at the domestic level (e.g., Alan Greenspan opting to keep interest rates low in 2002–2005). And, of course, the costs can be shared both by the country creating a particular policy as well as by foreign countries.

With respect to domestic costs, both the banking system and the financial markets are mechanisms to channel capital from those who have it to those who need it. As such, those providing capital often do so in the form of interest-bearing savings deposits, loans, notes, or bonds. Lower interest rates often mean that savers pay a significant price. On the margin, saving is discouraged and the benefits of thrift are undermined. There is a limit to how much the benefits of saving can be reduced before the incentive to save is destroyed altogether.

But interest rates also help determine how much a society spends today versus how much it spends in the future. So, lower interest rates also mean that a given country is borrowing demand from the future. The cost here, of course, is that demand in the future will be weaker than it otherwise would have been. So the benefit is higher GDP growth today and the cost is lower GDP growth in the future. Since the financial crisis, central bankers in major developed economies, like the United States, Japan, and Europe, have held short-term rates near zero for approximately seven years. That’s a lot of borrowing from the future.

With respect to foreign costs, a lower exchange rate for the domestic currency means that foreign exporters have more difficulty competing — which is why so many countries enter a currency war with beggar-thy-neighbor policies. Such policy objectives are achieved by expanding the monetary base. These reductions in the value of currency lead first to higher import prices, then to higher asset prices, and finally to greater inflation. It also means that many of the problems that led to the last crisis have been papered over. Lower quality businesses that should have been shuttered are still in business. Questionable borrowers still have questionable debt. Banks, in turn, own that debt, which increases systemic risk. True, such policies can give unsteady firms more time to resolve their problems, but they also remove the incentive to resolve those problems. So it is not clear what the net effect might be.

Lastly, rising asset prices, of both real and financial assets, are often a desired effect of central bankers. While rising asset prices might sound like an inherently good thing, it, too, has a cost. Those with existing wealth benefit at the cost of those without it. So such policies favor the wealthy in society over the poor. To the degree that monetary policy leads to inflation in goods and services, this cost is paid disproportionately by the poor who spend a much higher proportion of their income on basic necessities than do the wealthy.

Over time, asset prices cannot rise faster than their underlying intrinsic value for very long. If they do, the trend must eventually reverse as market participants cannot get a return on their investment. In the case of home purchases, which are typically leveraged, when and if prices decline, homeowner equity can be quickly wiped out and mortgage loans defaulted on, which in turn can jeopardize the highly levered banking system. Likewise, financial assets purchased by levered entities can easily wipe out owner’s equity, too. The cumulative effect of a long period of artificially low rates, such as the current post-crisis period, amplifies these costs materially and therefore weakens the private sector and the markets. These costs are now exceeding the benefits. In other words, the same monetary policies are experiencing diminishing benefits at the precise time the costs are growing.

No wonder we had a bifurcated distribution in our respondents’ choices. Central bankers cannot control the markets forever and the uneasy relationship they do have is now being challenged by erratic price movements in markets around the world.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

4 thoughts on “Are Central Banks Losing Control?”

  1. Bill says:

    Central banks are price fixers who distort the marketplace leading to malivestment. Now we look around and realize that the world is drowning in debt which was socialized by a small group of central planners who know nothing about the real economy.

    After this third and final bubble burst can we allow the market to allocate capital in a more free enterprise fashion or will we continue to finance crony capitalists that feed off the host?

  2. Chuck says:

    Short term gains and long term costs. Looking at a long term chart of the discount rate shows an unprecedented monetary environment. There is anxiety regarding the unknown level of these future costs.

  3. Bill says:

    ZIRP has fueled the greatest leverage within financial entities. Real economy has never been more detached from the financial markets. Ecosystem acting on numerous false and or unsustainable signals thanks to central banks socializing more of the economies.

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