Central banks don’t control the economy, people’s mood swings do

As a trader, you need to gain a basic understanding of how financial markets really work.

Many investors have a completely topsy-turvy concept of what drives the markets – and to follow the crowd is to court disaster.

When you understand what drives markets, your forecasts take on a logic that escapes the minds of most participants. You will be ahead of the game because you anticipated the market. The majority of traders react to events – and end up as losers.

It’s practically an unyielding law of economics that the financial authorities in every country attempt to control their economies: including interest rates, the rate of growth or decay, and even the rate of change in the CPI (consumer price index – a measure of inflation).

For instance, it is an article of faith that the US Federal Reserve has magical powers to control all aspects of the US economy. There is a whole army of ‘Fed watchers’ who do nothing more than attempt to decode every utterance made by anyone connected to the Fed for meaning. They use this analysis to forecast the markets, usually poorly.

Because my physics background at least taught me to question everything – and I do mean everything – let us examine this assumption.

But first, let me puncture a few illusions.

Can economics help in forecasting market moves?

In popular and professional circles, it is widely assumed that, when certain actions are taken by the authorities, a certain macro-economic outcome will be the result, as if the laws of economics were like the laws of classical physics.

For instance, it is a ‘given’ that lowering income tax will reduce tax receipts and raise GDP, and vice versa. It’s obvious, isn’t it? A smaller percentage taken of a pie means more pie remains.

However, this model does not take into account people’s behaviour when faced with a lower tax rate. Many will work harder, as they get to keep more of their pay, and so are encouraged to produce (and spend) more. So not only will the GDP pie get bigger, but if the percentage growth in the economy exceeds the percentage decrease in the tax rate, then tax receipts will rise, not fall.

On the other hand, if the tax rate is increased, many people might conclude that because they have less money left over in their pay packets, they will not work any harder. Their spending habits become conservative, and demand falls, leading to a smaller economy. And if the percentage drop in the economy is greater than the percentage increase in the tax rate, then tax receipts will fall, not rise.

Both scenarios are equally possible. So that puts economics in a difficult position. If the same government action can produce two opposing results, how can we make any forecasts? In 1980, economist Arthur Laffer explained this dilemma by proposing the Laffer Curve. He proposed that there is one single tax rate that would maximise revenue. Lower or higher rates than this would reduce overall receipts.

This idea has a large following.

But this, too, has a fatal flaw. It supposes that people are like robots – always reacting in the same way to the same stimuli under all conditions. But this is false.

It is people’s mood that determines the economy

In the end, it is the mental state of the people as producers and consumers that decides what happens in the economy. If people are feeling bullish, confident and expansive, they spend and the economy grows. If people are feeling bearish, fearful and conservative, they hold back, and the economy falls.

No amount of tax cutting or credit creation can change people’s mood. At present, people’s mood is generally bearish, and quantitative easing (QE) is akin to pushing on a string. The demand for credit is just not there, despite the urgings of the authorities. People just want to pay down debt, not take on any more. This is deflationary.

The one main implement that the Fed uses to ‘control’ exchange rates is the Federal Funds Interest Rate (and now, QE). Today, the US authorities are worried that their economy can only escape the pending depression by stimulating exports (and reducing unemployment) through lowering the dollar exchange rate. They are doing this through actual and threatened money printing (QE).

Recently, the Fed has come right out with it and confessed they are ‘targeting’ the CPI, which they say is too low (it hovers around zero). Yet despite the more-than $1 trillion injected into the banks in QE1 (6% of GDP), CPI has actually fallen. Does this sound like the Fed is in control to you?

To me, this is desperation, and the methods will almost certainly not work. The fact is the Fed follows interest rate movements in the open market. As a forecasting tool, Mr Market is supreme. And the one tool that can help us make highly reliable forecasts is the Elliott wave theory, which maps the ebb and flow of public mood precisely.

My conclusion? Macro-economics is mostly useless at helping us forecast market moves, except in the one major sense that if an overwhelming majority adheres to one particular view, we can look to bet against it with confidence. For example – many believe that QE will be hyper-inflationary, leading to gold rocketing to more than £3,000 an ounce. This is a very common view.

I shall be looking to bet against it!