Mar­ket swings ex­pose cen­tral banks’ in­flu­ence and lim­its

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

THE se­cond half of last week pro­vided fur­ther ex­am­ples of the in­flu­ence of cen­tral banks over fi­nan­cial as­set prices, and of the way they al­ter his­tor­i­cal as­set class cor­re­la­tions while con­tribut­ing to con­ta­gion. What didn't be­come any clearer last week, how­ever, was the long-term ef­fect of this dy­namic. With good rea­son: Cen­tral banks are in­creas­ingly los­ing con­trol of their own des­tiny and legacy. Let's start with the Fed­eral Re­serve. The mar­ket con­sen­sus was that the Fed's state­ment Wed­nes­day was in­suf­fi­ciently dovish. The cen­tral bank ac­knowl­edged the weak­en­ing of global eco­nomic con­di­tions, but it held back from giv­ing strong hints that it was ready to stop its tight­en­ing cam­paign, let alone en­gage in an­other round of stim­u­lus (as the Euro­pean Cen­tral Bank had sig­naled a week ear­lier). Yet, sur­pris­ingly, the Fed ex­posed a lack of con­fi­dence about the prospects for the U.S. econ­omy, par­tic­u­larly by omit­ting to pro­vide guid­ance on the "bal­ance of risks" fac­ing the econ­omy. The re­sult was an in­tra­day swing to the down­side in the Dow Jones In­dus­trial Av­er­age of more than 300 points. And the sell­off was quite in­dis­crim­i­nate, putting pres­sure on com­pa­nies dis­play­ing widely vary­ing fi­nan­cial re­silience and ex­po­sure to cen­tral bank liq­uid­ity man­age­ment.

On Fri­day, the Bank of Ja­pan went the other way, and the op­po­site ef­fect on mar­kets was equally no­table. Cen­tral bankers in Tokyo sur­prised mar­kets by fol­low­ing the Euro­pean Cen­tral Bank's ex­am­ple and tak­ing pol­icy in­ter­est rates into neg­a­tive ter­ri­tory. More­over, this ac­tion was ac­com­pa­nied by sig­nif­i­cant liq­uid­ity in­jec­tions by the Peo­ple's Bank of China. Stock traders took this as an in­di­ca­tion that global cen­tral banks were will­ing to ex­per­i­ment even more with stim­u­lus mea­sures. Global stock mar­kets soared, cul­mi­nat­ing in a 397-point gain for the Dow (2.5 per­cent). It was equally note­wor­thy that the surg­ing stock mar­kets on Fri­day were not as­so­ci­ated with a sell-off in govern­ment bonds, which are nor­mally seen as havens. On the con­trary, Ger­man bunds and U.S. Trea­suries gained in price, re­duc­ing the 10-year yield to 1.92 per­cent and 0.33 per­cent, re­spec­tively. This ad­di­tional ev­i­dence should erase any doubts about the abil­ity of cen­tral banks to in­flu­ence stocks in the short run, al­ter his­tor­i­cal as­set class cor­re­la­tions and fuel con­ta­gion within them. By con­trol­ling liq­uid­ity in­jec­tions and in­flu­enc­ing the rate of re­turn on "safe" govern­ment bonds, th­ese mon­e­tary in­sti­tu­tions still can af­fect sen­ti­ment, risk-tak­ing and the flow of cap­i­tal in (and out) of risk as­sets.

An open ques­tion, which is cru­cial to the well-be­ing of cur­rent and fu­ture gen­er­a­tions, re­lates not to the im­me­di­ate fi­nan­cial con­se­quences but, rather, to the longer-term ef­fects: Specif­i­cally, whether un­con­ven­tional cen­tral bank poli­cies can durably ben­e­fit the econ­omy, and whether they can do so in a man­ner that lim­its the col­lat­eral dam­age and the un­in­tended fi­nan­cial con­se­quences of a pro­longed ex­ces­sive re­liance on par­tial and ex­per­i­men­tal poli­cies. This ques­tion takes on added im­por­tance now that the sys­tem­i­cally im­por­tant cen­tral banks are on diver­gent paths (at least for now). Con­clu­sive ev­i­dence is still lack­ing, yet par­tial in­di­ca­tors -in­clud­ing the rather slug­gish U.S. gross do­mes­tic prod­uct data for the fourth quar­ter re­leased last week -- sug­gest that, at best, cen­tral bank pol­icy only can keep eco­nomic growth hum­ming at a frus­trat­ingly low level, and well below the econ­omy's po­ten­tial. This is con­sis­tent with my be­lief that -- de­spite their clear com­mit­ment, im­pres­sive dili­gence and ex­cep­tional ef­forts -- cen­tral banks around the world sim­ply do not have the right tools for the task of un­leash­ing gen­uine en­gines of growth, deal­ing with ag­gre­gate de­mand im­bal­ances, re­mov­ing crip­pling debt over­hangs and im­prov­ing global pol­icy co­or­di­na­tion. Un­til that changes, the in­flu­ence of cen­tral banks on longer-term eco­nomic well-be­ing will be but a small frac­tion of their short-term im­pact on fi­nan­cial mar­kets. The re­sult will be as­set prices that are de­cou­pled, from eco­nomic fun­da­men­tals, and in an in­creas­ingly volatile man­ner.

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