Attack the Week (ATW)

July 31st, 2023

Monday Thoughts

The month of July is almost over. And what an eventful one it was. In my latest post over the weekend, I reflected on the first month’s offering for Paper Alfa subscribers and set out a path as to what’s coming up in August. Also, a last reminder that today is the last day to benefit from a special discounted offer to get all-in access to all content. Do not worry, educational content will continue to be free.

Reflecting on last week’s central bank week, it is very refreshing to see that, for once, a central bank has chosen to loosen its stance on being overly predictable in its monetary policy actions.

Over the past decade, I only remember two occasions when central banks tried to be unpredictable. One occurred in 2013 when the Fed tried tapering its QE operations, while the other one was conducted by Powell’s hawkish “higher r-star” and u-turn in 2018/19.

On pretty much all other occasions, central banks have been overly focused on talking to markets, pre-announcing pretty much every step and reaction function and thereby rendering their policy inadvertently back to market forces.

This “overcommunication” strategy has now taken another small knock in my view when thinking about what the BoJ has just done last Friday. Although they kept the YCC band at +/- 50 bps, it no longer views this band as a rigid limit and will not look to rein the rate in via unlimited bond purchasing operations even if it rises above 50 bps. Rather, it will use such operations only if the long-term rate threatens to exceed 100bps. To this degree, the central bank has increased its ability to exercise discretion which is refreshing to see.

It reminds me of the time when Mark Carney (former Bank of Canada and Bank of England governor) was regarded as being an “unreliable boyfriend”. While somewhat of an uninspiring label, it is precisely how central banking should work.

You can not give away all information to the market. You have to let it guess, and then sometimes you need to surprise them so they learn a lesson that not everything can be fully expected. It is very much needed to retain monetary flexibility in light of the fact that their decision-making is, like any other, performed under large degrees of uncertainty.

There is an excellent speech by former Bank of England governor Mervyn King exactly to the point about how central banks can drive the expectations channel and hence also might not necessarily have to act upon them as market forces already do the central bank’s job.

He referred to it as the Maradona theory of central banking, which, in King's interpretation, is how central banks can handle inflation expectations. By surprising the market and not behaving as expected, a central bank can control inflation more effectively, he argued. If market participants are unsure about what the central bank will do next, they are unlikely to take assertive actions, allowing the central bank to have more control over inflation.

In essence, the theory emphasizes the importance of managing expectations and keeping market participants guessing to achieve the desired outcomes. This would mean, at times, central banks might need to behave unpredictably to prevent market participants from making moves that could destabilize the economy.

“This is what I call the Maradona theory of interest rates. The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice, is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half, beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.”

It is certainly worth thinking about this theory when contemplating the current monetary policy framework. Markets are expecting a dovish twist for the Fed even though they themselves have not been guiding those expectations. By manifesting this expectation within markets, the belief system is impacting economic outcomes. This, ironically, could underpin and support the Fed’s higher-for-longer stance. I would argue that this is precisely why we have seen bonds wrestle with this year so far.