Why ECB’s decision to reduce QE is a cause for concern
If governments, companies and markets needed any further reminders that their operating environment is changing, they got it last week.
Despite weakening economic momentum and volatile financial markets, a second systemically important central bank, the European Central Bank, reiterated its intention to stop using large liquidity injections to support economic activity and asset prices.
The change in this “global factor” is translating into a volatility “regime change” in markets, requires an evolution in investment strategies and calls for compensating pro-growth policy measures on the part of many individual countries.
The ECB’s announcement last week that its governing council still intends to stop large-scale asset purchases, known as quantitative easing or QE, at the end of the year occurred in the context of what central bankers acknowledge is an increasing list of threats to their economies.
After the central bank’s policy meeting, ECB president Mario Draghi said the risks include an uncertain trade regime, pressures in emerging markets, politics and the budgetary confrontation between Italy and the European Union.
And by stating that the “ECB mandate does not involve financing government’s deficit”, Mr Draghi emphasised the implicit message that neither governments nor markets can continue to rely on regular, large and predictable liquidity injections to offset their own problems.
The ECB’s signals reinforce those that the Federal Reserve has been sending for a while now. Despite weakness in housing, a historical indicator of cyclical trends for the US economy, and notwithstanding complaints by US President Donald Trump, top Fed officials continue to leave no doubt of their intention to further raise interest rates while reducing the bank’s balance sheet. Moreover, this Fed team, unlike its predecessors, is less inclined to resort to soothing words to calm unsettled markets.
The increase in market instability should come as no surprise. It was clear from early in this (now-ending gradually) exceptional monetary policy phase that the “unconventional policies” of central banks were aimed at repressing volatility as a means of promoting economic activity. Central banks have also been consistent and clear about their intentions to exit this phase as economic conditions allow.
The resulting journey away from the prolonged introduction of unconventional policies inherently involves more financial and economic volatility.
This is especially true given how much market participants have downplayed liquidity risk in certain segments and how many governments have been slow in in introducing pro-growth structural reforms.
What the destination will look like remains an open question, however. The outcome essentially depends on the orderliness and comprehensiveness of the hand-off to better economic and corporate fundamentals, as well as the reset of market technicals.
As I have argued, this transition is made more uncertain by the divergent economic performances within the advanced world, as well uncertainty about trade policy.
It will also be tested by two elements: pockets of excessive risk-taking that emerged during the previous period of ample liquidity (from the excessive reach for yields, including through off-benchmark investor exposures, to the spread of products that implicitly promise immediate liquidity at reasonable bid-off spreads); and the extent to which certain governments and corporates used the period of unusually low interest rates to pile on too much debt, creating excessive currency mismatches.
The message to governments, corporates and market participants is clear: central banks are completely serious about getting out of the business of suppressing volatility and the process could be approaching critical mass. Much like what happens to you when you take off those fancy noise-cancellation headphones in mid-flight on a plane and notice all sorts of noises around the cabin, markets and economies are becoming more sensitive as QE and guidance on low rates decay.
Economic actors and market participants need to prepare for greater environmental instability as monetary policy transitions away from unusual and experimental measures to historically more recognisable ones. This change has the potential to place both the global economy and markets on a more solid fundamentally based foundation over the longer term. But it also requires timely adaptations in both or the possibility of the better could give way to the agony of the worse.