The Cost-Benefit Mismatch of Monetary Policy

This past week, the two largest central banks--the Fed and the ECB--signaled that they would not run the monetary printing presses on overtime in the immediate future. The stock market promptly wailed, shrieked and then threw its pacifier across the room, recording its worst week in 2012. Once again, we see ever so clearly that the financial markets are dependent, above all, on government policy.

With political dysfunction in the U.S. and Europe the rule, not the exception, government policy has largely boiled down to central banking monetary policy. And that policy suffers from a mismatch of costs and benefits that makes it seem more attractive than it really may be.

When a central bank loosens things up, financial markets respond at warp speed. All asset classes rise in value. This increased correlation among asset classes, which has often displaced the more traditional inverse relationship between stocks and bonds, and between financial assets and gold, has made investing more a matter of guessing when central banks will run the monetary printing presses than of conducting any research or evaluation of economic fundamentals. But central bankers feel good because they can see tangible results of their policies in seconds, while receiving hardly disinterested applause from bankers and other Wall Streeters.

The full impact of monetary policy on the economy tends to take about 18 months to emerge. If policy is loosened at the risk of triggering inflation, the inflationary effect will manifest itself months and perhaps over a year after the loosening is implemented. The downsides of monetary policy, therefore, appear well after the financial markets deliver their huzzahs.

Enjoy now, pay the price later. Do people like to indulge too much in something that delivers positive feedback now while imposing costs later? Well, does a bear sit in the woods?

Central bankers, being human like the rest of us, are at risk of succumbing to the crack-like euphoria delivered in milliseconds by the order flow of today's high-speed computerized trading systems (which account for about two-thirds of market volume). The cost of cranking out low-cost credit isn't felt until later, much later. Some of the incumbents at central banks today may not even be in office when the downsides pop up.

This mismatch of costs and benefits from monetary policy may skew policy preferences, especially among central bankers predisposed to act rather than wait. Certainly, some central bankers resist the allure of short term positive feedback. It's been well-publicized, if sometimes anonymously sourced, that disagreement exists among members of the Fed's Open Market Committee, and between the Fed and the ECB. But an unmistakable trend in recent years of central banks to deliver stimulus, even at the risk of sparking inflation in the longer term, makes one wonder if the mismatch of costs and benefits of monetary policy might not be working mischief.