Tuesday, June 10, 2008

Expectations Schmexpectations (Example No. 16 of Government Intervention Run Amuck)

I get so annoyed with our central bank governors when they talk about "market expectations," as though these were something they, the governors, controlled by a mere syllable or two, when in fact they don't even know what they are.

[Thanks to Dr. Leila R. Brammer at homepages.gac.edu/~lbrammer/ for the image.]

To get an idea of how truly flakey economists' understanding of inflation expectations really is, read this speech by Supreme Economist Fed Governor Bernanke himself. I applaud his candid approach to this subject; but the vacuum of scientific knowledge is scary when you think that the Fed Board controls the world economy.

Jean-Claude Trichet, the European Union central bank governor, says in his own most recent speech that "inflation expectations must be controlled."

Although Trichet has earned a reputation for putting his actions where his mouth is, Bernanke is now addressing the inflation issue mainly through jawboning, saying things like, "The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation."

Okay, talk on. We'll wait for the action.

What the monetary authorities seem to want to brush under the rug is the following point:

Not only the central bankers' words but their anticipated actions have become a part of the market itself.

Here's how it works: The market participants listen to what the central bank governors say, and then they act accordingly.

Now, this doesn't mean necessarily that the market players heed the words. It may mean that they speculate on the effect of the words first, profiting from the immediate market movement; meantime, they have judged for themselves what the actual actions and outcomes of the words will be. They know well that sometimes the actions and outcomes are diametrically opposed to the words our central bankers utter.

For example, when the U.S. central bank governors instruct the market that they intend to "control inflation," the market knows that the general public might believe them and this may cause certain indices to move in the short term. However, for the long term the market players may know better and suspect that the Fed will continue to inflate at the slightest sign of economic trouble.

The words have now have become a signal to some market players that there is profit to be made in the short-term swings of public reaction to the words; but that in the long run, they can expect the opposite actions and outcome.

Speculators take action accordingly. Company management listens to the Fed governors, even using the words as an excuse to withhold pay raises for their employees. After all, they say to themselves, "[d]espite rising energy and food prices, Trichet said it was vital for workers in Western countries to moderate wage increases, which economists regard as the best way to avoid an inflationary spiral."

Okay, so employees must tighten their belt? But why then doesn't this prevent some of the more savvy market players, e.g. management of larger corporations, from skimming off the profit cream for themselves, or from using corporate funds to indulge in speculative activities a la Sears Roebuck?

In this example, it could almost sound as though management and the central bankers are in cahoots against the wage-earning public.

This may sound far-fetched; but it describes pretty much what is going on. Central bankers are asking wage earners to forego a salary increase even though this is supremely unfair given that the speculators and corporate CEOs are reaping record millions.

This means that the average Joe and Jane get stiffed on the pay raise as the cost of their food and gas is doubling. Meanwhile, higher management with their gawdy salaries--and the central bankers with their political hubris--apparently don't see the irony, or the potential dangers.

I've made a point of listing examples of government intervention gone amuck. This has got to be one of the best.

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