The Fed's goldilocks prob­lem

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

In re­cent days, eq­uity mar­kets have been whip­sawed by wild and rapid fluc­tu­a­tions, in­clud­ing a 588-point de­cline of the Dow Jones In­dus­trial Av­er­age on Mon­day (af­ter a dizzy­ing day of swings that spanned about 5,000 points), an ex­cep­tion­ally abrupt down­ward re­ver­sal late Tues­day, and Wed­nes­day's 600-point in­tra­day swing that cul­mi­nated in a fran­tic rally to the close. The bond mar­kets also have ex­hib­ited no­table volatil­ity: Ten-year Trea­suries have traded in a 25 ba­sis-point range in the last four days alone.

These ex­tra­or­di­nary moves, am­pli­fied by patchy liq­uid­ity, in­di­cate that mar­kets are strug­gling to find their right lev­els amid un­cer­tain­ties about both the health of the global econ­omy and the abil­ity of cen­tral bank poli­cies to re­store sta­bil­ity. Re­spond­ing to ac­cu­mu­lat­ing ev­i­dence of a slow­down in China and other emerg­ing economies, mar­kets have been ad­just­ing to the no­tion that these coun­tries no longer drive global growth, but in­stead have be­come drags. Yet the growth pic­ture has not been bad ev­ery­where. U.S. data sug­gest the do­mes­tic econ­omy is con­tin­u­ing to heal, in­creas­ing its re­silience to ex­ter­nal head­winds.

On the pol­icy front, even though mar­kets are more skep­ti­cal about the longer-term ef­fec­tive­ness of cen­tral bank poli­cies, they have taken note of new ac­tions that aim to pro­vide short-term sup­port. Since the mar­ket de­ba­cle Mon­day, fur­ther stim­u­lus mea­sures by China -- a mix of lower in­ter­est rates, a re­duc­tion in re­serve re­quire­ments and di­rect liq­uid­ity in­jec­tions -- have been ac­com­pa­nied by dovish re­marks from New York Fed Pres­i­dent Bill Dud­ley, who said a Septem­ber rate hike is now "less com­pelling." The re­sult­ing volatil­ity, though a boon to traders and high-fre­quency out­fits as well the bro­ker-dealer com­mu­nity, is likely to get a mixed re­cep­tion at the Fed­eral Re­serve.

The Fed would like to see mar­kets grad­u­ally be­come less com­pla­cent about the un­cer­tain­ties pre­sented by the flu­id­ity of the global sys­tem. And the cen­tral bank would like to slowly wean them off their ex­ces­sive re­liance on its un­con­ven­tional poli­cies of re­cent years. As a re­sult, the Fed would be com­fort­able with mar­ket volatil­ity that is higher than the av­er­age lev­els of the last few years. At the same time, the Fed dreads ex­ces­sive mar­ket volatil­ity be­cause of its po­ten­tially detri­men­tal ef­fect on eco­nomic ac­tiv­ity. For the last few years, cen­tral bankers in much of the ad­vanced world have acted to re­press such volatil­ity as a way to boost as­set prices in the hope of en­cour­ag­ing con­sumers to spend more and com­pa­nies to in­vest more in plants, equip­ment and peo­ple.

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