Part of my article below actually appeared in the Hindu Business Line Link a few days back, made some additions to the original post and re-posting it.
Even after two decades when it was decisively established that the forces of invisible hand are far superior to the command and control structure in bringing about the economic growth and prosperity, the Central Bankers across the world have not stopped trying. Perhaps the human urge for power and to feel that he is in control of his surroundings may also be playing a part; the belief that they have the might and the power to control the business cycles and to do away with recessions is evident in the dramatic increase in their interventions in the asset markets this past decade and now with the global economy in a flux ever since the financial crisis of 2008 it has increased further. Like the financial derivatives, the asset classes (equity, commodity, fx, bonds and real estate) are derivatives on the real economy and hence their price action is just a forward looking reflection of the economic condition. Thus a high volatility in any one of these asset classes can be a harbinger of the perilous state of the economy and so ever since bouncing off the abyss in 2008-09 the Central Bankers and Planners try to control the behaviour of the asset class that starts to exhibit high volatility.
With years of intervention we have reached at a crossroad where the Central Banks have completely lost their control over the only component of the asset market where they actually had one; “the yield curve”. This became apparent in the late 90s in Japan and then finally here in US, when the Fed after propping up the property market in lieu of the busted Nasdaq bubble tried to control the elephant from turning into a dinasour by increasing the Fed Funds Rate in June 2004, however it soon found that it has completely lost control over the yield curve as the graph below demonstrates:
So from June 2004 to August 2005 the Fed funds rate increased from 1% to 3.75% however the 10 year yield was at best flat; result - the property boom couldn’t be slowed down and the elephant actually grew bigger leading to the ofcourse eventual dramtic collapse. So as is apparent from the graph above, the Fed lost control of the yield curve almost 6-7 years ago however even now the Central Banks are living in a cinderlla world as is apparent by the announcement of “Operation Twist”.
The recent announcement of the Swiss Central bank to peg the Swiss Franc against the euro shows how this contagian to control the asset markets is spreading like a wildfire and in turn leading to a mispricing of assets and thus aggravating the economic situation. Let me elaborate further by picking on this example, so to maintain this peg the Swiss Central Bank would have to print as many CHF as it would take. Now because of the peg the volatility in the CHF-EUR currency market would diminish however the question that one should ask is what would one do of the new swiss francs that have been created, well using that the market participants would buy more of bonds/stocks/commodities etc. and thus what happens is that volatility would spill over and add to the existing volatilities in other markets, in essence volatility is not destroyed, just transferred.
To establish how the volatility from this currency pair has moved into the other asset classes, below are the charts of standard deviation (volatility in simple words) of the daily changes in the CHF-EUR currency pair pre and post the announcement of the peg and a similar chart for the equity pair of the Swiss Stock Index to the French Stock Index i.e the (SMI/CAC ratio) for the same two periods. Please note that in order to have a similar comparison with a "currency pair" it's important to pair the Swiss market with a major Euro market as this would remove the effects of the volatility due to the broad common macro moves thus bringing about clearly the volatility impact due to the currency peg, also I am excluding the market data on the announcement day as we are interested in what happens "pre" and "post" peg announcements.
A brief glance at these charts would tell you that even though the Swiss Central Bank was succesful in reducing the volatility of the CHF-EUR currency pair, however the unforseen impact of their action has been that part of the currency market volatility has moved into the Swiss stock market as exhibited by the volaitlity of the SMI/CAC ratio which has almost doubled post currency peg announcement
All this shows the ineffectiveness of the actions of the Central Banks as not only the volatility from one asset class moves to the other asset class thereby keeping the overall volatility in the system as same but excess of control would mean the volatility entering into the broad economy which is precisely what they intended to control to start with and so instead of taking the signal from the asset class exhibiting high volatility their actions leads to a mispricing of assets and thus aggravating the economic situation.