The Pak Banker

Market swings expose central banks’ influence and limits

- 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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