Publication - How much should we read into shifts in long-dated yields? - Speech by Mr Hyun Song Shin, Economic Adviser and Head of Research of the BIS, at the US Monetary Policy Forum, New York City, 3 March 2017.
The “market” is not a person
I mentioned that storytelling is a powerful device in economics. Let me start by telling you a story myself. My story is about a bell. It’s not the famous bell at the New York Stock Exchange down the road from here, but a bell in the cathedral in Mexico City.
In 1947, a novice bell ringer died in an accident when he tried to move one of the cathedral’s bells while standing underneath it. The bell was then “punished”: its clapper was removed and the bell was sentenced to be tied down. It was renamed La Castigada (the “punished one”). The sentence was commuted in the Catholic Church’s Jubilee of 2000, and the bell is now allowed to ring again, but it is still known as La Castigada. There is a YouTube video of the story.
The idea of “punishing” a bell runs counter to modern sensibilities, but before we get too smug about it, we should ask ourselves whether we are committing a similar mistake. If you have ever caught yourself saying that the market expects this or that, you have committed the same mistake. This is an example of what philosophers call a “category mistake”. Wikipedia defines a category mistake as “a semantic or ontological error by which a property is ascribed to a thing that could not possibly have that property”.
Of course, speaking of the “market’s expectation” is fine as a shorthand for market prices. The difficulties arise when we take the shorthand literally. The temptation is to anthropomorphise the market, and endow it with foresight that is misplaced. The market is not a person. Market prices are outcomes of the interaction of many actors, and not the beliefs of any one actor. So it is a mistake to project consistency and foresight onto a place where it does not belong.
In spite of this, most discussions of central bank forward guidance treat the market as if it were an individual that you can sit down and reason with. Transparency over the path of future policy rates is seen as a device to manipulate long rates. And crucially, such manipulation is seen as something amenable to fine-tuning. But by thinking of things in this way, I believe we are in danger of committing a category mistake, just like those who punished the bell, where we anthropomorphise the market as an individual with beliefs. Let me reinforce this point by offering a straw man, the expectations theory of the yield curve, which holds that long-dated yields are pinned down by the expected future path of short-term rates. The empirical validity of the expectations theory is questionable, to say the least, but it has exercised a powerful hold over economic commentary, especially among central bankers.
Let me read you a passage from a Brookings Papers piece from 1983 by Bob Shiller, John Campbell and Kim Schoenholtz about the hold that the expectations theory of the yield curve has over central bankers:5 The simple expectations theory, in combination with the hypothesis of rational expectations, has been rejected many times in careful econometric studies. But the theory seems to reappear perennially in policy discussions as if nothing had happened to it ... We are reminded of Tom and Jerry cartoons that precede feature films at movie theatres. The villain, Tom the cat, may be buried under a ton of boulders, blasted through a brick wall (leaving a cat-shaped hole), or flattened by a steamroller. Yet seconds later he is up again plotting his evil deeds.
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