Streetwise Professor

June 29, 2013

The Fed Plays a Global Game, and Loses

Filed under: Economics,Financial Crisis II,Politics,Regulation — The Professor @ 7:21 pm

The Fed is reeling at the violent market response to Bernanke’s statements regarding the eventual taper of Quantitative Easing.  High level Fed officials flooded the zone last week, making soothing noises and arguing that the market had overreacted to Bernanke’s words.

There is some solid economic theory that predicts that the public release of “small” pieces of information can lead to big changes in behavior and market outcomes.  Specifically, the theory of Global Games (see a variety of paper written by Morris and Shin, in particular) predicts that the release of objectively trivial information can lead to a discontinuous jump from one equilibrium to another in coordination games.  The Fed is quite consciously playing a coordination game: it is trying to coordinate the expectations of market participants with the understanding that market outcomes depend quite crucially on consensus beliefs and expectations that tend to be self-fulfilling This is precisely why the market hangs on every Fed statement, every Bernanke utterance.  And this is precisely why a seemingly benign public statement with little information content can lead to a big market move.  It’s inherent in the game the Fed is playing.  They really shouldn’t be all that surprised.

The game the Fed is playing is actually even more complicated than those analyzed in the Global Games literature.  Specifically, there is a reflexivity and endogeneity in the Fed expectations game.  That is, in the real world game game, the Fed responds to the market’s response to the Fed’s actions, and on and on.   That’s not taken into account in the Global Games models, makes things even more complicated, and adds another level of beliefs on which the players of the game (which includes the Fed, prominently) must coordinate.

This is why QE and other exceptional monetary policies are so fraught with danger and risk.  This makes chess look like checkers.  Mistakes will be made.  You will pay for them.

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  1. “mistakes will be made. You will pay for them”

    Care to elaborate? More volatility, I can understand. Anything more specific – or you prefer just being ominous?

    Comment by thoreau devotee — June 29, 2013 @ 10:23 pm

  2. @thoreau-More volatility, with substantial tail risks. Tail risks include an inflationary spike (though I used to think this more of a risk than I do now), the risk of a serious downturn, the risk of a renewed financial crisis (many channels through which this can occur). Just the uncertainty inherent in this situation is a drag on growth.

    The ProfessorComment by The Professor — June 30, 2013 @ 7:12 am

  3. Low forever has in effect mispriced just about all risk in existence. It’s simple finance and math: Making PV denominators so insignificant makes relative valuation overly dependent on risks that cannot be foreseen or priced. Nominal returns depend on forward rates beyond anyone’s (least of all the Fed’s) forecast horizon. Real returns depend on inflation stable longer than any reasonable investor would be willing to believe in or sees on a day to day basis. Default rates depend on rolling over the leverage low forever has encouraged, with all the uncertainty in growth that still hasn’t been addressed by worldwide populist politicians. Everything from markets to sentiment to global trade flows become overly dependent on circular “animal spirit” arguments. Why else would correlations between everything skyrocket like they have? Investors are throwing up their hands at being able to manage these risks, and moving to cash as a result.

    Comment by dh — June 30, 2013 @ 1:26 pm

  4. “There is some justification in the taunt of many of the pretending defenders of “Free Enterprise” are in fact defenders of privileges and advocates of government activity in their favor rather than opponents of all privileges. In principle the industrial protectionism and government-supported cartels and agricultural policies of the conservative groups are not different from the proposals for a more reaching direction of economic life sponsored by the socialists.” F. A. Hayek

    Comment by Bob — July 1, 2013 @ 9:04 am

  5. The paying has already begun: FNMA 3.5′s in July went from 106-2(!!!!!) to 100-6 in about 5 weeks. This is the sort of nonsense we used to see in 1979/87.

    Comment by sotos — July 1, 2013 @ 11:55 am

  6. An end to quantitative easing is inevitable, and whenever it is done, it’ll make markets roil. It can’t be avoided so might as well take the medicine now. Fed should not panic, but hold the course and begin increasing rates. It needs to reel in the credit before yet another bubble forms.

    Comment by Chris — July 2, 2013 @ 12:55 pm

  7. @chris-I agree. Take the medicine now, rather than do things that exacerbate imbalances and malinvestments. Given that the real impacts of QE on employment and growth were pretty clearly minimal, and its effect on asset markets pronounced, it should have backed off long ago. Sadly, the bubble has formed already. The Fed should have gotten off the tiger before it had become full growed. @dh has a pretty good diagnosis.

    The ProfessorComment by The Professor — July 2, 2013 @ 2:33 pm

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