When a measure becomes a target, it ceases to be a good measure. That restatement of Goodhart’s Law is almost perfectly appropriate to today’s financial markets. Bonds, stocks, currencies and commodities have all become treacherous terrain for investors.
Charles Goodhart, a British economist, developed his law in 1975. He was worried about the central bank orthodoxy of the day, the belief that monetary policy should aim only at controlling money supply. Growth in M2 and inflation rates had long been closely correlated, but as soon as the monetary authorities started to work on M2 the correlation broke down. Inflationary momentum stopped passing through this measure of the money supply.
The current generation of central bankers has put its trust in another historically strong correlation: between asset prices and economic activity. They believe that high asset prices lead to GDP growth because they inspire confident consumers to spend and companies to borrow. As an added benefit, the cheap and free money which pumps up asset prices also pushes down currencies, a boon to exporters.
The post-crisis loose monetary policy did push asset prices up and many currencies down, but economic growth remains pretty sluggish. It seems that markets do not move the economy in the same way when they are heavily drugged by the monetary authorities as when their enthusiasm is more natural.
Now, instead of central banks learning about the economy from markets, investors study the economy largely in order to anticipate what central banks will do. And investors study each other, trying to guess their peers’ response to changes in policy expectations. Meanwhile, central bankers monitor investors, trying to keep them confident.
All of this mutual attention makes markets behave like a group of narcissistic teenagers. Both respond emotionally to every little development – in ways that are unpredictable and difficult to analyse. Markets gyrate when the Fed or the Bank of Japan sounds a tiny bit less dovish, or when the unemployment rate is a tiny bit higher or lower than expected.
Monetary authorities think strong asset markets and weak currencies will help growth, but their financially orientated policies are now more confusing than helpful.