Those who have heard of Karl Pilkington probably know him as the guy in the TV show An Idiot Abroad. However, it was the podcasts with Ricky Gervais and Stephen Merchant (co-creators of The Office) in the mid-2000’s that earned him cult status, for his often misinformed but hilarious views conveyed in a ‘thinking out loud’ style of conversation. There is even a website dedicated to his most ludicrous opinions and quotes: http://www.pilkipedia.co.uk.

One of Karl’s classic quotes came from his thoughts on how the body works, posing the question: “Does the brain control you, or are you controlling the brain? I don’t know if I’m in charge of mine”. (Have a listen on this YouTube clip)The quote inspired laughter but what’s funnier is that Karl may have been unknowingly touching on a branch of philosophy known as the “philosophy of mind”, which explores the relationship between the mind and body, as well as concepts like ‘what is consciousness?’

Feedback Loop

The philosophy of mind is some deep stuff, but if Karl was to think out loud on the financial markets and the obsession with central bank policy, perhaps he might ask: ‘Do the central banks control the markets, or do the markets control the central banks?’ Who is in charge? Some people might think it is a stupid question with an obvious answer. However, there is a complexity to this question, given the dynamic nature of the world, the interdependent relationships that exist and a feedback loop that is difficult to quantify.

Over the last six years central banks have used financial markets as a mechanism for inspiring a recovery in the real economy. The “wealth effect theory” – which postulates that rising asset prices make consumers “feel wealthier”, causing them to spend more – has been the prime driver behind their expansionary monetary policy. So in this sense, one could argue that central banks are in control, providing an environment that is conducive to risk-taking behaviour, driving asset prices higher and motivating the all-important consumer to spend more, often using borrow funds, to promote economic growth.

While the validity of the wealth effect theory is questionable, in terms of the actual impact on the real economy, there is no debating the influence of central bank policy on financial markets.

In Association with

Markets In Control

Still, one could also argue that it is the financial markets who have taken control of the central banks. There is the obvious fact that many of the figureheads at the world’s major central banks have come from the most powerful financial institutions, the name of one particular investment bank springs to mind. But from an actual policy perspective, central banks have taken the lead from the financial markets in setting monetary policy. ‘The market is calling for...” and so go the headlines.

For example, take the most important central bank of all, the US Federal Reserve. Every time they have come close to a rate hike, the financial markets have wobbled, forcing the Fed to delay raising rates and to eventually add more monetary stimulus. The sell-off that preceded the Fed’s decision on Thursday was clearly a major factor in choosing not to raise interest rates for the first time in nine years.

The Fed has inferred from the market that all is not well, taking a wait-and-see approach before raising rates. However, market participants have inferred from the Fed’s inaction and downbeat tone that there may be real cause for concern in terms of a slowdown in the global economy. Neither side really knows how things will evolve, but the financial markets are reacting like they’ve suddenly woken up to the fact that the Fed are not in control. They are winging it.

Unhealthy Dependency

After all, when you look behind the curtain it’s just Janet Yellen and the rest of the board governors. They have no more ability than other market participants to see into the future. Their policymaking that preceded previous crises should tell you that. The Fed and the other major central banks are in experimental territory, with the end game impossible to call.

Who is in control? Let’s just say central banks have nurtured an unhealthy co-dependency with market participants. Breaking that unhealthy relationship will be easier said than done. Both sides are starting to realise that.

Vincent McCarthy, CFA, is a Senior Investment Consultant with Invesco