Inside the Market’s Mind: Central Bankers’ Biases

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"I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it’. Yes, what we need is a positive attitude and conviction. Indeed, each time central banks have been confronted with a wide range of problems, they have overcome the problems by conceiving new solutions."
-Governor Kuroda, Bank of Japan[1]

The Bank of Japan (BOJ) surprised markets at the end of January by joining other central banks in dropping its deposit rate into negative territory (-0.1%). This move came despite Governor Kuroda’s assurance, expressed only the week before, that the BOJ had no intention of doing so. What made him change his mind (assuming he wasn’t lying before)? Are central banks showing herding behavior and has Kuroda succumbed to the comfort of ‘groupthink’ (perhaps after a few nice meals with fellow bankers in idyllic Davos)?

Behavioral finance has highlighted numerous, often subliminal, biases in the decision-making process of investors. These biases result from heuristics which are rules of thumb or mental shortcuts.[2] This can be extended to other economic agents, like central bankers.[3] So, in this article I’ll highlight the main biases among central bankers. They should be of serious concern to investors, just like their own biases.

Last October we published “From ZIRP to NIRP”, discussing the likelihood of (US) rates dropping into negative territory as well as the implications. This topic received a new impetus late in January when the Bank of Japan (BOJ) surprised markets by lowering its deposit rate to minus 0.1%, joining the Danish, European, Swedish and Swiss central banks which had already introduced negative rates. Janet Yellen, chair of the US Federal Reserve (Fed), indicated that the Fed is studying whether negative interest rates would help should conditions worsen.

The total amount of developed-market government bonds trading with a negative yield recently rose to a record high of almost US$6 trillion, representing roughly a quarter of the JPM Global Government Bond Index. Specifically, in Europe more than a third of all bonds are trading with a yield below zero. Although we are some way off from seeing triple-A corporates issuing new debt on negative yields, clearly the universe of safe securities that offer any positive yields is getting smaller.

Investors chasing the same investments is a direct consequence of central bankers chasing the same policies, with complex feedback loops between these actions. Central banks are using monetary tools to manipulate prices, in particular interest rates. They combine it with communication strategies, like forward guidance, that make their decision-making more transparent and predictable. This is all aimed at influencing investor behavior. In behavioral finance parlance, central banks try to “nudge” investors into “desirable” behavior, implicitly assuming that investors suffer from biases that interfere with rational decision making and prevent outcomes that are optimal for the economy.

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However, central bankers are also subjected to biases. Failing to recognize this is a bias in itself, called the blind-spot bias. In the case of central bankers biases are manifested slightly differently; they are much more prone to influences from group dynamics. This is due, first, to the academic culture in which central banks are embedded. Academia in general is vulnerable to groupthink, as recently highlighted by the FT economist John Kay[4]. In this case, it leads to the fairly dogmatic adherence, across “the board”, to mainstream monetary theory which frames problems in a much more uniform way than is usually the case. For example, its DSGE[5] model is the first port of call that immediately anchors their views. Related to this is the Fed’s “dot plot” which contains policymakers’ forecasts that, subliminally, morph into their expectations, anchoring decision making and enforcing the illusion of knowledge. Second, groupthink is also caused by the isolated and fairly secretive way (justifiably or not) in which their meetings takes place, including those between central banks. In short, central banks are a breeding ground for biases.

With this in mind, let me list my selection:

  1. Overconfidence, also known as the hubris bias, is generally accepted to be an overarching bias. It is closely related to over-optimism and is supported by the illusion of control and the illusion of knowledge. Admittedly, central bankers need to project a certain amount of confidence in order to maintain the credibility and trust that our fiat monetary system requires. But they can overdo it. My argument that central bankers, broadly across their membership, are suffering from this bias is predicated on the fact that they have consistently failed to reach their targets, in particular inflation. Moreover, their forecasts on interest rates have been off the mark (chart 1).

    Chart 1; Long Grass, Blowing in the Wind
    successive boe forecasts bank rate
    Source: FT

  2. Cognitive dissonance is the (uncomfortable) mental state of having conflicting thoughts, beliefs and feelings which can negatively influence decisions. It is the typical disposition of the two-armed economist, i.e. “on the one hand, but on the other…” An example among central bankers is Janet Yellen who recognizes that the Fed’s policies are beneficial for Wall Street but is concerned with the fate of Main Street. In other words, she has acknowledged that inequality is a problem and perhaps she is worried that “her” monetary policy may have worsened it.

  3. Prospect theory suggests that people value losses and gains differently in decision making. Loss aversion is its particular manifestation, and one variant applicable here is the sunk cost fallacy. Also known as irrational escalation it is the tendency to continue to stick to a decision because of the existing costs (e.g. reputation) committed so far to that decision, even if there is evidence that the decision is wrong. Some readers will immediately recognize that this applies to QE. In addition, I would argue that the Fed’s long intended decision to raise rates already falls into this category.

  4. Self-attribution is the tendency to judge successes as being based on one’s own hard work and skill, whereas failures are due to others’ incompetence or bad luck. It often occurs in combination with hindsight bias. I only need to refer to the various biographies of past central bankers to make this point. However, I also consider the liberal use of “data-dependency” as an excuse to take credit when the economy does well and blame outside events for negative developments.

  5. Herding occurs in collective settings and is the tendency to think and act like the majority, often driven by the popularity of the latest gimmick (i.e. hype) which, initially, is picked up by a critical minority. The growing acceptance of NIRP is the latest phase in a bandwagon effect where the common strategy is to debase currencies, a tit-for-tat, reflecting the fear of regret of missing out, i.e. being too late to the party.

  6. House money effect is the tendency to take more and/or greater risks with profits that were generated on previous trades. This bias falls into the category of mental accounting whereby the money at stake is considered “extra” or “not yours”. Central banks broadly have no profitability requirements, nor liquidity constraints. Still, the Fed, for example, has been extremely profitable over the past decade (chart 2). The temptation to “bet the house” is thus large.

Chart 2. House Money: Growing Profits and Growing Risk
federal reserve remittances us treasury
Source: http://www.federalreserve.gov

Many biases overlap in definition and effect. In light of unprecedented policy measures, investors may now be suffering the illusion of control by central banks, for example. Also, the above list is not exhaustive, neither in the type of biases nor in the ways that they manifest themselves. To select biases from central bank behavior is like picking sweets from a candy store: the choice is almost overwhelming. For example, I could have mentioned that Mario Draghi is likely to suffer from the hot-hand fallacy, that Bernanke’s wealth effect is a placebo effect (at best, money illusion at worst), and so on and so forth.

In their defense, central banks will argue, for example, that they all face the same threat of global deflation, and thus need to act in a similar fashion. They will also counter that they have implemented “de-biasing” measures to diminish these biases. For example, decision-making by way of committee voting limits the influence of biases emerging from individuals, particularly dominant leaders. The BoE has created a blog on its website as a forum for open discussion. All these initiatives are commendable but do not address the main underlying issues which I’ll discuss in the technical note below.

To conclude, in light of the biases that dominate among those listed above, particularly overconfidence and the sunk costs, investors should expect that central bankers will continue to show ever more extreme behavior. Eventually, it will likely include a retooling of monetary policy to finance fiscal policy, i.e. some variation of helicopter money, as well as an abolishment of cash. This prospect makes investing even more difficult, although maintaining a well-diversified multi-asset portfolio, with a growing weight to real assets, is probably the right approach. But I may be overconfident.

Technical Note

The “underlying issues” brings us to the key role of the unconscious which generally is assigned to, what behaviorists call, “System 1” in decision making. In this article I have treated biases and heuristics from the dominant view in behavioral finance, something I call the Kahneman doctrine. It basically states that they are bad. However, in broader discussions concerning behavioral finance, the role of heuristics, emotions and particularly intuition is still debated. Specifically, there are a number of experts, including Gigerenzer, Klein, and Damasio, who disagree with Kahneman.

Generally the influence of the unconscious is acknowledged by all camps. The level of influence grows 1) with the number of people involved and 2) with the level of abstractness of the symbols their mental activity is involved in.[6] This clearly applies to price discovery where a large number of people are “dealing in numbers”. However, the role of the unconscious is not devious per se. For example, it plays a crucial role in facilitating the mind to endogenously generate the internal surprises, i.e. insights, in order to deal with external ones.[7] But any benefits are at risk as soon as we start to demonize the unconscious and repress the intuition and emotions that originate from it.

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This, unfortunately, is exactly what happens when the dominant paradigm in economics, from which monetary theory is derived, suffers its own blind spot bias. Mainstream economics and modern finance treat the economy, respectively the market, as machines which require engineering solutions to problems. Colored by a physics complex, it is a form of physicalism that ignores the mental domain, particularly creativity. Moreover, it has actually caused many of those problems and involves other biases, like automation bias. As I have explained elsewhere, facing up to this “hard problem” clearly goes beyond addressing some simple heuristics.

On that note, my writings also expose one of my personal biases: anthropomorphism, the tendency to attribute human characteristics to other, in this case economic, phenomena. In particular I attribute a mind to the market and equate many economic issues to be the consequences, or symptoms, of collective mental disorders. In terms of biases, we collectively suffer from loss aversion, for example. This mainly concerns debt. We (at the societal level) are afraid to take the hit and much rather continue to rely on renewed promises to repay, passing the buck to future generations. The psychology surrounding debt is archetypal, if only because it is ancient and universal across cultures. But that is a topic perhaps for another time.

Finally, for those who are interested to learn more, I highly recommend the PBS documentary series “The Brain”, aired in the UK by the BBC. In particular, episode 3 deals with the unconscious while episode 4 deals with decision making.

Quiz:

Guess which biases you can identify in Mario Draghi’s statement to the European Parliament, earlier this month, regarding the ECB’s quantitative easing package: “Without these measures, the euro area would have been in outright deflation last year and—Growth would have been significantly lower.”

References:

[1] Source: https://www.boj.or.jp/en/announcements/press/koen_2015/ko150604a.htm/

[2] E.g. Kahneman, D. “Thinking Fast and Slow”. 2012, Penguin Books.

[3] E.g. Haldane, A. 2014. “Central bank psychology”. Bank of England.

[4] “Political groupthink is bad for our universities”, FT, 02/02/2016.

[5] Dynamic Stochastic General Equilibrium

[6] This was among the main insights from psychologist Carl Jung, for example.

[7] E.g. http://www.financialsense.com/contributors/patrick-schotanus/economic-equality-conscience

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