Friday, November 29, 2013

What's a central banker to do?

I'm not the first to notice this, but I thought it worth a brief blog post anyhow: Financial markets these days react less to economic news than to anticipated central bank reactions to economic news. This often produces the "bad news is good news" paradox. An example from  today is:
The euro headed for a third monthly advance after a report showed inflation in the region quickened more this month than economists forecast, fueling bets the European Central Bank will refrain from further stimulus. 
By normal rules, quickened inflation should be bearish for a currency. It means that in terms of goods and services that the unit is losing value. This is less important to traders, evidently, than the likely reaction of the central bank which would take the form of higher than previously expected interest rates paid on the sovereign debt denominated in the unit. Meanwhile, (also from the Bloomberg report):
Sweden’s krona dropped as a report showed the economy expanded 0.1 percent in the three months through September, after contracting a revised 0.1 percent in the second quarter.
Swedish inflation has been running far below the official 2% target.

This poses an interesting dilemma for central bankers. Under current theory, raising expected inflation is supposed to stimulate recovery, (the main mechanism being allowing real wages to fall thereby stimulating employment), but if interest rates and forex rates rise as a result then, again under current theory, that would be deflationary and anti-stimulative. What's a central banker to do? The current answer seems that the central bankers have to demolish their hard earned credibility as inflation fighters and convince markets that they have become irresponsible. (No, seriously!)

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