Time and time again the markets have moved in the opposite direction that policymakers intended; the result of so-called quantitative easing by the US Fed and the interest rate hike in China are good examples

Powerful governments feel that they have the ability to manipulate markets in furtherance of a policy agenda. Investors often invest accordingly. In the United States for example, the saying is "don't fight the Fed" (the US central bank). The reality is that the market always wins.

One of the more spectacular recent examples has to do with the US Federal Reserve policy of quantitative easing. The Fed and its chairman Ben Bernanke have told us that the reason for quantitative easing was to avoid deflation, drive down interest rates, and stimulate growth. Although not one of their stated purposes, it was obvious that this policy should have weakened the dollar. It was also supposed to create a "wealth effect" by driving investors from the supposed safety of government bonds to more risky investments.

Despite the howls of protest from economists throughout the world and disagreement on its own board, the Federal Reserve decided to go forth. The market of course had other ideas. Interest rates rather than declining have gone up. The interest rate on the 10-year US treasury bond used to be about 2.48%. Today they are almost 3%. Thanks to the Irish crisis, the dollar has strengthened against the euro. It has also strengthened against the Japanese yen.
 
The Federal Reserve has been successful in creating inflation. Both food and oil prices have increased around the world, often negatively impacting some of the poorest members of society. Yet, members of the Federal Reserve committee remain unrepentant. This week, in a speech, one of the members of the committee blithely dismissed the rise in nominal interest rates as misleading, rather than entertain the possibility that the policy was simply wrong.
 
Of course it is not just the Federal Reserve or the divided US government who get policy wrong. China's leaders have often been lauded in the past for their economic management which has lifted millions from poverty and created rapid economic growth. But then again, many used to think that Alan Greenspan, the former Federal Reserve chairman walked on water too.
 
The reality is that the combination of a partially reformed economy and massive bank loans have created the potential for an inflationary nightmare that may be exceptionally difficult to control without a dramatic economic contraction.
 
Normally to rein in runaway inflation governments and central banks raised interest rates. Most observers of the Chinese economy expect that this will happen and it will have the desired effect. It won't.
 
Interest rates are anti-inflationary for three reasons. First it makes it more expensive for consumers to make purchases. Secondly, higher interest rates normally drive down equity and bond prices, which lowers consumption as consumers feel poor. Finally higher interest rates make investment more expensive and lower growth can increase unemployment.
 
Professor Pettis of Peking University's Guanghua School of Management points out that these assumptions in China are wrong. Raising interest rates in China may not slow inflation. First there is very little consumer financing in China, so raising interest rates may not have much of an impact. Second, since much of the wealth of China is contained in bank accounts, raising interest rates, if allowed to flow through to those deposits, could actually increase demand and inflation. Finally, raising interest rates may not slow investment or employment partially because so few of the loans are actually paid back.

What Professor Pettis does not point out, is that raising interest rates in China might have a more dramatic effect. Interest rates in a market economy have different impacts on different businesses and consumers. So a rate hike might take time to make its way through the system. In a partially reformed command economy like China's, the government calls the shots. The rise of interest rates sends an enormous signal throughout the economy that the government intends to slow things down. So, rather than make different decisions, businesses and consumers all make the same decision at the same time. This could have a rapid and dramatic impact on the economy as it did in 2008 when the economy ground to a halt even before the US meltdown.

Government policy makers often have the wrong tools. The tools they do have are often used for the wrong reasons, often short-sighted and political. The policies are invariably based on incomplete, inaccurate, and even false information, which in different systems can result in different effects. Sometimes it is surprising that they get any policy right.

Investors spend a great deal of time and money analysing the policies of various governments. The assumption is that if an investor can determine the direction of government policy, he can determine the direction of the market. What often occurs is that the markets have other ideas. Investors, who don't fight the Fed, will sometimes find that they have to surrender to the market.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])