Saturday, 24 October 2015

The Fed mandate for chocolate

17:53 Posted by The Thalesians (@thalesians) No comments

For a moment, imagine you are in a chocolate shop or one which sells delightful cakes (as above). I suspect, your objective is to buy some chocolate or something similar. It is unlikely that you are visiting in order to lose weight. If you have a mandate to lose your weight, then visiting a chocolate shop somewhat conflicts with that. However, if your mandate, is occasionally enjoying some chocolate, you have probably come to the right place.

In this instance, it is easy to formulate a mandate for behaviour. More importantly, it is easy to see whether we have stuck to our mandate or we have broken it. For any job, you are essentially given a mandate, which governs how you behave. Often, the mandate can be more implicit, rather than explicit. Let's say you are a trader. Your mandate involves maximising P&L, whilst at the same time ensuring that risk is managed prudently. Other aspects of the mandate are also important, for example ensuring compliance with the rules of your institution and of the market. If you overshoot your risk limit repeatedly, you are breaking your mandate. If you repeatedly flout rules around market behaviour, you are not keeping your mandate.

The behaviour of central banks is also governed by mandates. If we think of the Federal Reserve, their mandate involves striving for: maximum employment, stable prices, and moderate long-term interest rates. Sometimes obviously, these multiple objectives can conflict with one another, and they need to temporarily emphasis certain elements of the mandate. There are some things that their mandate doesn't include:

  • hiking, because the market is fed up with waiting for hikes
  • hiking, because traders are finding it difficult to generate P&L
  • hiking, to do the "right thing" and teach people a lesson who are on the wrong side of the trade
  • cutting, because stocks aren't high enough
  • cutting, to boost trader's P&L

Yes, central banks make mistakes and sometimes they can stick too rigidly to some of their mandates. Trichet's hikes in 2008 and 2011, were generally seen as policy mistakes at the time (and even more so afterwards). The Fed has also come in for criticism for the length of its asset purchase programme. Yes, maybe the impact of QE waned over time. But the initial Lehman shock was so severe that it called for unorthodox measures and the Fed could not simply walk away. In addition, the TARP program, which was sanctioned by Congress, also helped to stablise the market, by giving banks some breathing room and remove the very real possibility of a collapse in banks. Yes, it essentially was a bail out of the banks, but again think about what would have happened without TARP. Would Main Street really have been "better off" with a collapse of the banking system? Somewhat I think the Fed's mandate for maximum employment, would have been dented.

It's very easy to criticise central banks, and sometimes that criticism is warranted, they make mistakes too. At the same time, their mandate is very much different to that which governs the behaviour market participants, so what market participants might want, might not be best for broader economy. On a more focused look at when the Fed might actually hike, I'd also recommend reading Des Supple's latest note on the state of the US economy at present and what it means for when the Fed might hike.

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interested in me writing something for you or creating a systematic trading strategy for you! Please also come to our regular finance talks in London, New York, Budapest, Prague, Frankfurt, Zurich & San Francisco - join our group for more details here (Thalesians calendar below)

25 Nov - London - Panel - Macro Markets Discussion
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