Thursday, November 27, 2014

The Threat to the Central-Bank Brand

NEW YORK – The “branding” of modern central banking started in the United States in the early 1980’s under then-Federal Reserve Board Chairman Paul Volcker. Facing worrisomely high and debilitating inflation, Volcker declared war against it – and won. In delivering secular disinflation, he did more than change expectations and economic behavior. He also greatly enhanced the Fed’s standing among the general public, in financial markets, and in policy circles.

Volcker’s victory was institutionalized in legislation and practices that granted central banks greater autonomy and, in some cases, formal independence from long-standing political constraints. To many, central banks now stood for reliability and responsible power. Simply put, they could be trusted to do the right thing; and they delivered.

As any corporate executive will tell you, brands can be consequential drivers of behavior. In essence, a brand is a promise; and powerful brands deliver on their promise consistently – be it based on quality, price, or experience. In some cases, consumers have been known to act on the strength of brand alone, even purchasing a product with relatively limited knowledge about it.

Indeed, brands send signals that facilitate the task at hand. In some special cases – think of Apple, Berkshire Hathaway, Facebook, and Google – they have also acted as a significant catalyst for behavioral modification. In the process, they often insert a wedge that essentially disconnects fundamentals from pricing.

Building on Volcker’s success, Western central banks have used their brand to help maintain low and stable inflation. By signaling their intention to contain price pressures, they would alter inflation expectations – and thus essentially convince the public and the government to do the heavy lifting.

In the last few years, however, the threat of inflation has not been an issue. Instead, Western central banks have had to confront market failures, fragmented financial systems, clogged monetary-policy transmission mechanisms, and sluggish growth in output and employment. Facing greater challenges in delivering desired outcomes, they have essentially pushed both policies and their brand power to the limit.

This is apparent in central banks’ aggressive emphasis on communication and forward policy guidance. Both have been used more widely – indeed, taken to extreme levels – to supplement the unconventional expansion of balance sheets in the context of liquidity traps.

Now, corporate executives will also tell you that brand management is a tricky affair. It is particularly hard to maintain or control your brand when popular sentiment overshoots.

This is what happened to Apple’s stock this year. As brilliantly explained by Guy Kawasaki in his book on the company, the brand essentially created “enchantment.” Extrapolating this into a market view that Apple could not only innovate continuously, but also fend off any and all competitors, investors took the company’s share price to dizzying heights.

Elsewhere in California, Facebook found its brand fueling enormous hype for the company’s initial public offering. Encouraged by investor excitement and indications of over-subscription, underwriters hiked the IPO’s price well above what they had first deemed reasonable. Issuing the stock to the public at an inflated price a year ago, the shares initially traded even higher.

In both of these cases, and in many others, brand power did more than lead to price behavior that was disconnected from fundamentals; it also caused a dangerous overshoot, which, when subsequently reversed, damaged the brand.

However powerful, brands cannot divorce pricing from fundamentals entirely and forever. Accordingly, and despite a significant market rally that has taken many individual stocks to record highs, Apple and Facebook currently trade at almost half their record levels. Their dominance and influence are no longer unquestioned.

Western central bankers should spend some time reflecting on these experiences. Some have actively encouraged markets to take the prices of many financial assets to levels no longer warranted by fundamentals. Others have stood by passively. Indeed, it seems that only retiring central bankers, such as Mervyn King of the Bank of England, are willing to raise concerns publicly.

This behavior is understandable. Central bankers are basically hoping that financial-market hype by itself can help pull fundamentals higher. The idea is that price action will trigger both the “wealth effect” and “animal spirits,” thus inducing consumers to spend more and companies to invest in future capacity.

Count me among those who worry about this situation. Far from a world of optimal policy, central bankers have been forced into prolonged reliance on imperfect approaches. From my professional vantage point, I sense a mounting risk of collateral damage and unintended consequences.

Market signals are more distorted, fueling resource misallocations. Investors are piling on more risk at increasingly elevated prices. Fundamentals-based investing is giving way to a frantic search for relative bargains in an increasingly overpriced financial world.

All this will not matter much if central banks live up to their reputation as responsible and powerful institutions that deliver on their economic promises. But if they do not – essentially because they are not getting the required support from politicians and other policymakers – then the downside will involve more than just disappointed outcomes. They will have materially damaged their standing and, consequently, the future effectiveness of their policy stance.

By extending well beyond their comfort zone, today’s central banks face unusual brand-management risks. Their prior ability to deliver on promises and expectations has made today’s financial markets take the forward pricing of the economy to levels that exceed what central bankers alone can reasonably deliver.

The implication is not that central banks should immediately halt their hyper-activism and unconventional measures. It is that they should be much more open about the inherent limitations of their policy effectiveness in current circumstances.

Western central bankers need to become much more vocal and, one hopes, more persuasive in placing pressure on politicians and other policymakers. Otherwise, risking major brand damage, they will end up adding yet another item to an already-overloaded plate of challenges for the next generation.

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    1. CommentedHeriberto Arribas

      In 1980's Paul Volcker drained the money that flooded the economy. But it was not a matter of intelligence but of luck. A breach was make in the dike and the money flowed and inflation disappeared. The money went to the financial market, and this grew. Now the problem is the opposite, too much money is coming out of the breach, deflation.

    2. CommentedJohn Brynjolfsson

      Brilliant essay highlighting that markets should not take Central Banks' current brand recognition as a given.

      This, it seems to me, is warranted in context of recent equity market reaction to weak economic statistics, and to anticipated CB policy reactions.

      Author suggests policy makers need to ratify this brand reputation, via meaningful fiscal policy response.

      I would instead, and perhaps Dr. El-Erian intended to implicitly, take this a step further, by highlighting that policy makers may be called upon to backstop CB solvency.

      Though some theorists (unfamiliar with all the literature on this topic) take CB solvency as a tautology, I do not.

      In particular, as CB's load their balance sheet with long duration, low coupon fixed coupon bonds, or worse with credit risk, even typical declines in asset prices could render CB's technically insolvent. The Fed, ECB, virtually all CB's have exposure that puts them at risk. In a scenario where CB assets fall in value, currency market participants will then demand that more than CB's "brand" is backstopped by government policy makers; capital injections will be needed. If they are not forthcoming, much more than the "CB brandname" is at risk.

      Gold, which El-Erian and PIMCO's Gross have at least mentioned in their writings tangentially, is perhaps the only hedge for that risk.

    3. Commentedarnim holzer

      The superimposition of brand management over the traditional concepts of stewardship and prudence is a challenging essay. To imply that "brand" equates to market confidence and therefore effectiveness is a bit too shallow in the light of the gravity of the world's circumstances. From the US' early formation until WW1 the US was the world's largest debtor, mostly due to private capital flows, and it was critical for Charles Hamlin the first prsident to maintain stability during WW1. The kind of challenges our patriarchs of banking face can only be effectively resolved and worked out in an independent and longer term basis similar to the independence of the judicial system. During times of crisis, it is this independence, steady hand, and longer term thinking that has protected the financial system from a complete meltdown with one major exception. In fact, during the years just prior and during the early great depression the Fed was overly sensitive to political sway and was too loose then too restrictive excacerbating the crisis. Central banks have helped defeat the pernicious inflationary threat of the 1980s and will likely set a floor on the disinflationary forces of the late 1990s to present. They did this by being measured and somewhat dispassionate not by being overly worried about what the markets or policymakers thought. It never seemed to me that Chairman Volker particularly cared about his or the Fed's image. While I don't want to underestimate today's challenges, the 1980s were a very difficult time with high teen interest rates where the concern over the sanity of the Fed was in serious question. The skewness of the Fed's balance sheet seems odd to us today but the mortgage rates of the 1980s were just as repugnant to those that had lived through the great depression and the two world wars.

      While I agree with Dr. El Erian that the current situation is concerning, I think Central Bankers have taken as proactive an approach as they are allowed and adviseable within their limitations. The progress against the major issues of fiscal imbalances, bad demographics, unemployment, and income inequality cannot be attained in the short term by worrying too much about image. In fact, it actually may be more helpful to remain somewhat detached as a doctor and allow the patient to start taking some responsibility for their own health as well.

    4. CommentedProcyon Mukherjee

      Let me give two examples of the threat that the Central Bank brand poses, as it comes hot from the latest BIS paper:

      Just stumbled on the 4th June speech in the BIS paper titled : Global liquidity: where do we stand- By Jaime Caruana ) where the graph on page 14 (graph 14), where the Developed World Money Multiplier (M2/M0) or Broad Money by Base Money has shown a sharp decline from the peak (2008) when it was at 10.5 to currently at 6.2, while the emerging markets have shown the constantly moving upward slope to touch 12 currently; the illusion of money multipliers is finally breaking as Central Bank assets have expanded exponentially in the Western World, while the emerging world is still in its infancy.

      The second is the graph 16, which shows the negative term premium of the major bond markets, which would mean that “given central bank removal of bonds from private hands, the term premium – the extra reward for bearing the price risk and inflation risk of holding a fixed rate bond – has flipped into a penalty that the investor must pay. “ This is an adjustment process that any exit would leave immense surprises.

    5. CommentedProcyon Mukherjee

      The Central Bankers had more like a sinecure existence till the time financial markets started to bloom and blossom and the brand thereafter had been carefully nurtured with an end in mind; bankers are bankers, central et al, they are more public than public can be.

      The cause of central banking has taken a new turn, the market waits for the hint or a whiff of a sententious speech, either from breakfast tables or dinner, so that trade can commence with the sole purpose of speculation, not for long term view of things; markets anyway have a one day memory, at the most, so bankers can move from one performance to the next with their character and poise.

    6. CommentedFrank O'Callaghan

      El Erian is right in so far as he goes and he touches on serious issues but there is much more at stake than "brand". The huge inequality gap, higher productivity and unemployment, impoverishment of the great majority in the west, industrial migration to 'investor friendly' economies and the transformation of states from service providers to enforcement and tax gatherers is changing the face of the world.

      There can be no long term future in fundamentals if there is not long term security and prosperity of the great majority. Redistribution is needed urgently.

    7. CommentedTomas Kurian

      The question is: if the FED did nothing and USA unemployment would climb to 15-20%, would it mean that FED would get this required support from politicians, which is not getting now ? (split congress, etc...)

      If you look at Europe, ECB is doing barely nothing, situation here is terrible and the politicians are still far, far from doing their heavy lifting.

      Surely 25-30% unemployment would change anything ?
      Maybe, but maybe not. The danger is great.

      It is for sure that transmission channels based on stock price increases are rather weak and there will be some price to pay someday, but being European, I would trade ECB for FED any day.