"Whatever it takes"

In the world of game theory, a credible threat is defined really by what it is not.  That is, a non-credible threat is a strategy a rational participant would never take because its never in their best interest to do so. Numerical examples are often somewhat unrealistic with one or two step payoffs and strategies, but the real world does provide instances of credible and non-credible threats, albiet with shades of grey.

The interesting case in financial markets at the moment comes from central banks.  Providing credible forward guidance can be in some ways more powerful than intervening in markets, with policymakers sometimes getting a bigger effect on interest rates and currencies without ever intervening directly in markets.

Two prime examples come from the ECB and the incomming BoJ governor, both have claimed to do "whatever it takes" to overcome crisis and restore growth.  Both times this statement has been used it has been positive for markets and in the case of Japan provided a big depreciation in the Yen.

Are these threats credible? Certainly markets believe there is a significant probability that it is, particularly given the changing of the guard at the highest level of policymaking.  But I think its worth remaining skeptical.

In the case of the ECB, the mere mention of Outright Monetary Transfers (OMT) has sent sovereign bond yields falling, which has taken a huge amount of systemic pressure off the Eurozone financial system.  This program, however, is much more conditional than bond buying by other central banks.  And furthermore, there is no sign of them actually doing it anytime soon.

Indeed, the ECBs balance sheet is actually shrinking as 3-year LTRO money used to support banks is repaid by those that are able.

This could prove to be a classic case of the mere threat of intervention ensuring that its not needed, but there is surely a significant risk that markets will test this assumption, particularly if economic prospects don't improve much.

The Bank of Japan has actually been increasingly interventionist in the past 12 months by ramping up the scale of asset purchases.  But what has had a bigger impact on financial markets is the election of Shinzo Abe, who has taken a more activist approach to economic management and the BoJ, installing a new governor.

Things like having a new 2% inflation target is hardly radical, although the new Governor Kuroda is apparently more willing push for more unconventional policy.  This, combined with new fiscal policy has had the nice effect of driving a significant depreciation in the Yen.  This has not been as large in real effective exchange rate terms, which is still someway from pre-crisis levels.  But nominal deprecation is much more palatable to inflation outcomes.

Again it is the promise of something different that has shifted Japanese financial markets and the Yen.  But they actually haven't done anything yet.

Against these examples, it is surprising how much conjecture there is surrounding the Federal Reserves intentions on asset purchases.  To me they are the most credible of the three, given they have continuously proven to be more dovish than markets expected and have been relatively aggressive in asset purchases.

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