Signal,noiseandBenBernanke

Yesterday we had a conversation with one of our readers and he was gracious enough to give one very deep insight. The insight was on the ratio of noise and signal in any kind of news. As per him if his transaction frequency is once in six months then daily news blabber is more of a noise because it is prompting him to act on a timeframe which is much smaller than his comfort. Now there are two things to understand here. Firstly, the signal quotient of any information depends on your transaction frequency and secondly a lot of news which appears important and urgent may not have signal value in the long run.

Our readers would note that when it comes to global market news, we take special interest in three phenomena; one is GDP growth, second is inflation and the third one is Jobs. The outlook which we present is sufficiently long term (signal) and the news regarding the daily market movements (noise) is more of a side dish rather than the main course. The effort always is to glean some long-term signal which might be hidden somewhere between the din of noise. Today lets again see how the combination of the jobs, growth and inflation impact on any economy and how the policy makers respond to the same.

Inflation and growth concerns elicit responses on the monetary side. The monetary medicine of rate and QE gives rise to capital movements. As the excess money gets generated in the host economy and it finds itself in a low rate environment it seeks out foreign shores where it can generate a better yield. The exact vehicle for this transfer is immaterial, it can take the form of FDI, portfolio flows, loans, global bonds but the key is to understand that the flow will happen as soon as the rate imbalance is created.

The recipients of the flows then have to take the rear-guard action. The flows impact the currency values and their currencies start appreciating. The evasive action is mostly in the form of reserve creation. Now this reserve is deployed in the bonds and treasuries of the source country (read mostly the US). Now readers should start to see the circularity of the whole operation here. The capital flow which happened initially from DM to EM was reversed when the EM’s CB mopped up the Dollar and sent it back to the US Fed buying US bonds. The only difference is that Dollar liability sits on the private books whereas the Dollar assets sit on the CB’s balance sheet. The net capital flows remain small.

Sometimes in case the country is also gaining Dollars by running trade surpluses this phenomenon can also give rise to reverse capital flows. That is a developing country supplying capital to the developed one by buying their capital assets. Now we know from Economics 101 that marginal utility of capital in a developed economy is much lesser than a developing one. So, this whole operation is effectively promoting inefficient use of capital (on a global scale). We have used Dollars (US Dollar) as a proxy for a developed country’s currency as the US Dollar remains the prime most player anyways.

There is a speech by former US Fed chief Ben Bernanke delivered on November 18, 2010 by the name “Rebalancing the Global Recovery”. It is a recommended read and presents the arguments from the DM pov, he writes that agreed that capital flows to EM’s complicate their domestic policy management but this problem was created by their penchant to control their currency value and supporting jobs in the export sector. He exhorts the other CBs not to intervene in the market and let all currencies find their natural value.

We will pause here (to continue later) and hope that we have presented some signal value today even if it was a rambling one.