My father used to say, "The central bank should be like God. You should never see him or hear him unless there is a crisis." Of course, Dad cut his teeth in the era of fixed exchange rates and relatively quiet markets, which may explain his observation. At that time, central bankers were grand old men who hardly interacted with the market and only descended from their mountain very rarely to announce some dramatic event, like devaluation.
However, with the end of the Bretton Woods system in 1971, the world gingerly moved towards floating exchange rates and the relationship between central banks and the market (which began to assert itself more and more) took on a different hue - adversarial would, perhaps, be the best word to describe it. There were many skirmishes fought in the foreign exchange market. In some of these, the central banks relented and raised (or lowered) interest rates as markets were demanding; in others, they simply fought back against the market with successful intervention.
This adversarial tension came to a head in September 1992 when George Soros and other traders sold sterling short (against the Deutsche mark) when it hit its floor in the European Exchange Rate Mechanism (ERM), betting that the Bank of England would not be able to raise rates to defend sterling when the UK economy was on the brink of a recession. The Bank of England intervened furiously and made several statements that it was forced to retract in a matter of days, and sterling was ignominiously booted from the straitjacket of the ERM that it had joined just two years previously. This was seen as a major victory for markets over central banks, and may well have accelerated the path to where we are today with central bank transparency almost an article of faith.
While in principle no one would disagree that central banks should be transparent and communicate their approach clearly, the current practice has degenerated into telling the market very specifically what to expect. While this unorthodox practice - akin to playing poker with a group of sharks with your cards face up on the table - was, perhaps, justified when the economy was slipping into a terrifying abyss, its continuation even when growth had restarted is tantamount to providing a valuable gift to the very financial sector that regulators have been trying to contain. Being closest to the market, it is obvious that financial players are best positioned to take advantage of the free put; unsurprisingly, financial sector profits as a percentage of total corporate profits in the United States have again risen to 25 per cent or so (from the more normal 10-12 per cent levels seen in the 1980s).
Central banks need to recognise that the financial sector is, by definition, an adversary - central banks have macroeconomic and financial stability goals, financial players' goal is to make money. Now, of course, you need to talk to your adversaries, both to keep them informed and to learn about what they are thinking. But you need to keep your cards close to your chest.
And, you need a strategy. My father, who was quite a poker player in his younger days, having supported the family for a number of years off his winnings at the card table, used to say, "To win at poker you need luck, but to win consistently, you need experience." His approach was to build a loud persona, blustering a lot so other players thought he was always bluffing; of course, he did bluff once in a while, and sometimes lost a goodly sum, but it was only to keep them honest, as he said. He also taught me that loud shirts often work as a handy accessory.
The good news for India is that the new player at the table is winning, so far at least. When he first sat down and shuffled the cards, he told it like it was - my job is to keep the money sound, deregulate markets more rapidly, and, of course, prevent the rupee decline from spiralling out of control.
Then, simply affirming what he had said, he raised the repo rate at his first opportunity at the mid-quarter review in September. The market was shocked. "But, but, but..," it said, and continued sputtering for a while. However, by the time of the second-quarter review this past week, the market appeared to have got his measure and, when he raised interest rates again (and, of course, kept his foot steady on the deregulation pedal), it cheered like hell.
He hasn't yet bluffed, but soon enough he may have to. Perhaps, I should send him a bright tie. And, much more importantly, Janet Yellen a bright red dress.
jamal@mecklai.com
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