How central bankers get timing wrong

Parenting is not easy, especially if parents have a history of indulging over-dependent children.

Parenting is not easy, especially if parents have a history of indulging over-dependent children.

This is the challenge for several central banks after so many years of both explicit and implicit support for financial assets. And it was made even more concrete by the enthusiastic market response on May 19 to the (probably inadvertent) timing of a speech by a Federal Reserve official that followed the particularly harrowing midweek selloff in stocks.

Forced to use the “asset channel” as the main vehicle for pursuing its macroeconomic growth and inflation objectives — that is, boosting asset prices to make consumers feel wealthier and spend more, and also to increase corporate investments by fueling animal spirits — the Fed has ended up providing exceptional multiyear support to financial markets using an experimental array of unconventional tools and forward policy guidance.

Indeed, most investors and traders are now conditioned to expect soothing words from central bankers — and, if needed, policy actions — the minute markets hit a rough patch, virtually regardless of the reason. And that is what ended up happening last week, yet again.

Worried by the latest White House twists and turns related to allegations about Russian involvement in the election campaign, the S&P 500 slumped on May 17 in the biggest selloff this year, as markets raised the execution risk tied to President Donald Trump administration’s pro-growth policy announcements on tax reform and infrastructure. The sharp selloff increased concerns that the beneficial impact of ample liquidity may be offset by lagging fundamentals.

The subsequent price action on May 18 was quite tentative — but that changed notably the next day, when the markets heard from James Bullard, the president of the St Louis Fed.

By suggesting that the Fed may need to be more stimulative than it has signaled recently, the comments spoke directly to many years of market conditioning and over-indulgence — specifically, Bullard observed that recent economic developments “may suggest that the FOMC’s contemplated policy rate path is overly aggressive relative to actual incoming data.”

The issue wasn’t the content of Bullard’s remarks. The views he expressed in his wellcrafted speech are understandable given the recent patch of soft economic data, together with lingering uncertainty as to whether this is truly temporary or indicative of a persistent structural headwind. Indeed, there is room for genuine discussion, debate and further research. But it is the timing that is more problematic, as it fuels — once again — the deeply-ingrained view that central banks are the markets’ BFFs.

Bullard’s comment, made in the context of ample market liquidity (both actual and perceived) — short-circuited any meaningful market consideration regarding the prospects for pro-growth fundamentals. And this is a needed and important process, especially given the degree to which asset prices have already been decoupled from fundamentals.

I certainly don’t intend to say that central bankers shouldn’t share their latest views on economic developments and how these influence their policy thought. They should, and they must. But like parents who need to carefully reduce their kids’ over-dependency to better prepare them for the future, they have no choice but to pay greater attention to timing. Given where the relationship between markets and central banks is coming from, when a central bankers chooses to speak has become as important as what he or she says.