I have been wanting to write this for quite some time ever since I read the chapters of the BIS Annual Report, 2015-16 recently (in January). BIS question the judgement that bond markets are efficient and that low inflation of the last quarter century was a product of central bank policies and their independence. First, on inflation:
Inflation is a highly imperfect gauge of sustainable economic expansions, as became evident pre-crisis. This would especially be expected in a highly globalised world in which competitive forces and technology have eroded the pricing power of both producers and labour and have made the wage-price spirals of the past much less likely…. international supply chains can be a powerful mechanism through which global factors impinge on domestic inflation, regardless of domestic capacity constraints.
In the highlighted portion above (my emphasis), BIS economists have spelt out their model of inflation determination. In other words, low inflation does not meant that the prevailing economic and financial market performance is a sustainable one.
On long-term interest rates set in and by the financial markets (Emphasis mine):
All estimates of long-run equilibrium interest rates, be they short or long rates, are inevitably based on some implicit view about how the economy works. Simple historical averages assume that over the relevant period the prevailing interest rate is the “right” one. Those based on inflation assume that it is inflation that provides the key signal; those based on financial cycle indicators – as ours largely are – posit that it is financial variables that matter. The methodologies may differ in terms of the balance between allowing the data to drive the results and using a priori restrictions – weaker restrictions may provide more confidence. But invariably the resulting uncertainty is very high.
This uncertainty suggests that it might be imprudent to rely heavily on market signals as the basis for judgments about equilibrium and sustainability. There is no guarantee that over any period of time the joint behaviour of central banks, governments and market participants will result in market interest rates that are set at the right level, ie that are consistent with sustainable good economic performance. After all, given the huge uncertainty involved, how confident can we be that the long-term outcome will be the desirable one? Might not interest rates, just like any other asset price, be misaligned for very long periods?
It is hard to visualise such (well justified) scepticism of markets coming from any advanced country central bank head.