One of my favourite Scott Sumner blog posts is on the connection been monetary policy failure and the impact of political news on the financial markets. I have quoted Scott many times on this issue, but let me do it again:
I once read all the New York Times from the 1930s (on microfilm.) You can’t even imagine how frustrating it was. They knew they had a big problem. Then knew that deflation had badly hurt the economy (including the capitalists.) They knew that monetary policy could reflate. And yet . . .
Weeks went by, then months, then years. Somehow they never connected the dots.
“Monetary policy is already highly stimulative.”
“There’s a danger we’d overshoot toward too much inflation.”
“Maybe the problems are structural.”
“There are green shoots, things are getting worse at a slower pace. The economy needs to heal itself.”
“Consumer demand is saturated. Even workingmen can now afford iceboxes and automobiles. We produced too much stuff in the 1920s.”
And the worst part was the way political news kept slipping into the financial section. Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc. In the 1930s the readers didn’t know what came next—but I did.
It has been a long time since political headlines really have been able to move the global financial markets (remember the fiscal cliff story never really did it). However, just take a look at these two stories from today:
Ten-year Spanish government bond yields rose on Monday as the country’s opposition party called for the resignation of Prime Minister Mariano Rajoy over a corruption scandal.
Ten-year Italian government bond yields also rose on concerns that a scandal involving Monte Paschi bank could see a rise in the popularity of the centre-right party in the polls, whose election charge is being led by former prime minister Silvio Berlusconi.
Since August-September the Federal Reserve and the Bank of Japan the have moved in the direction of easing monetary policy and a significantly more ruled basked monetary policy and even the ECB has eased up with ECB chief Draghi’s promising to do “whatever it takes” to save the euro. And Mark Carney has given investors hope that the Bank of England will move towards some form of NGDP level targeting. As a result the “euro crisis” has more or less disappeared from the headlines in the newspapers’ “financial section” (just take a look at what Google trends has to say).
Hence, it seems pretty clear that the markets’ “responsiveness” to political worries is a function of the tightness of global monetary conditions with tighter monetary conditions leading to a bigger impact of political jitters.
So where are we now? It to me all dependent on the ECB. If the ECB move towards a clearly rule based regime – in a similar fashion as the Fed and the BoE (and likely soon also the Bank of England) then we are likely to see markets becoming more immune to political jitters. On the other hand if the ECB moves back to the bad habit of conditioning monetary policy on political outcome then once again the markets will start worrying about the finer details of Italian and Spanish politics.
PS Some would argue that European monetary conditions have become tighter recently as a result of higher money market rates and yields. However, I don’t think that is the case. Higher yields and rates reflect growth optimism – just look at European stock markets and implied inflation expectations in the European fixed income markets. Market Monetarists don’t run for the door in panic when yields rise – rather we argue that you should not make the interest rate fallacy and confuse higher (lower) rates/yields with tighter (easier) monetary policy. As Milton Friedman reminds us rates and yields are high (low) when monetary policy has been easy (tight).