The Rising Risk of Central Bank Instability
Separate comments last week from European Central Bank President Mario Draghi and Federal Reserve Chair Janet Yellen confirmed an ongoing change in the policy configuration facing their two systemically important central banks: The recognition of a transition in both economic conditions and prospects, along with questions about robustness and durability.
For now, their response is to maintain a stimulative direction to their policies, and to use verbal guidance that avoids rocking the boat. Although it's consistent with investor expectations, the forward-looking policy path may not be as secure and smooth as market pricing would suggest, however.
In both Europe and the U.S., nominal gross domestic product trackers have been ticking up on indications of both higher inflation and higher growth, while fears of a deflationary trap have receded. At the same time, the administration of President Donald Trump has repeatedly signaled its intention to increase infrastructure spending, and the prospects for that happening are higher now that there are Republican majorities in both houses of Congress.
The two speeches given by Yellen late last week, together with Draghi's news conference on Thursday, acknowledged the improved economic conditions. Still, both institutions are resisting, at least for now, the notion that this foretells inflation and asset pricing that leaves monetary policy "behind the curve." In addition, they were quite guarded in their comments on the prospects for fiscal policy in the U.S., preferring to wait for more concrete evidence of an actual shift.
The recognition of a changing economic situation and the possibility of looser fiscal policy have not proven sufficient, at least for the moment, to trigger a modification in policy signals. Instead, the two central bank leaders reiterated last week the guidance that was provided at earlier policy meetings, thereby seeking to retain considerable flexibility. In doing so, they reaffirmed a balance of risk preference that has been a constant of their policy approach since the 2008 global financial crisis.
In formulating policies -- especially in an unusually fluid global economy -- central banks must consider not just what can go well but also the mistakes they could end up making, albeit inadvertently. This entails an effort to limit possible known mistakes to those they can afford to make and undo relatively easily over time.
Facing an unusually timid cyclical response and a challenged structural one, central banks have again demonstrated that they would rather err on the side of too much stimulus rather than too little, despite the risks entailed for future financial stability and the efficient allocation of resources. And that is what traders and investors have gotten to expect after observing and internalizing central banks' preferences over the last few years. Indeed, in the case of the U.S., market pricing related to the policy rate still suggests less tightening in 2017 than the three hikes indicated by the Fed at its most recent policy meeting and reiterated in subsequent statements by individual Fed officials. These more subdued interest-rate expectations also extend beyond 2017, to the medium-term path of policy rates, again notwithstanding what Fed officials have signaled about that.
But the more central banks persist with this approach amid changing economic and fiscal conditions, the greater the potential need for a sudden shift in monetary policy that, while economically warranted, could be quite jarring for markets. And it is a possibility that investors may be underestimating as judged by market metrics, including measures of implied volatility.
While the upward movement in yields further out the curve for U.S. government bonds would likely be contained by arbitrage flows from Europe and Japan, the foreign exchange market does not benefit from such a moderating influence. As such, the dollar could be being set up for some consequential volatility.
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Mohamed A. El-Erian at firstname.lastname@example.org
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