Central Banks Face New Dilemmas as Markets Rally

Decisions by policy makers may supercharge financial conditions and lead to a market correction.

It's a critical week for central banks.

Photographer: Michael Nagle

Markets have enjoyed a sustained rally on low volatility caused, in part, by uncertainty about the outlook for fiscal policy. Financial conditions have loosened substantially, which has presented a window of opportunity for central banks to tighten policy. The dilemma for central banks is how quickly monetary policy accommodation can be removed against the backdrop of political uncertainty and below-target inflation. The consequences could be supercharged financial conditions that may cause real interest rates to fall too far and lead to a market correction.

To guard against financial instability, monetary policy has remained looser than policy makers would like. The European Central Bank sees stronger growth but is cautious on inflation. This has caused a policy divergence within the ECB where the bias for lower rates has been dropped but quantitative easing, or asset purchases, continues. This policy divergence created a situation where the euro’s real effective exchange rate rose and bond yields turned more negative. Both of those situations create a headwind for the stronger growth needed in the euro zone in order for inflation to rise to the ECB’s 2 percent target. For those reasons, the ECB may decide to extend QE into 2018.          

The ECB’s Negative Rates and Euro

Source: Bloomberg

The Bank of Japan has tapered its QE program by reducing asset purchases across the yield curve, except for 10-year maturities. This barbell approach has made the yen captive to the spread between U.S. and Japanese 10-year yields, effectively “pegging” the currency to the dollar. Long-term yen hedging costs have fallen, providing cheap funding to global investors, contributing to the looser global financial conditions. But because the yen is heavily influenced by Federal Reserve policy, which has contributed to its recent strength, the Bank of Japan may have to adjust its policy of trying to control the yield curve in order to keep the yen from getting too strong and causing deflation to return.  

The Bank of Japan’s Tapering and Japanese Yen

Source: Bloomberg

The surprise outcome of the U.K. snap elections not only weakened the pound but loosened financial conditions there even further. Political uncertainty about Brexit negotiations may weigh on the domestic economy and that could cause the pound to depreciate back to the $1.20 levels seen earlier this year, keeping financial conditions loose while putting upward pressure on inflation. The Bank of England should tighten policy, but given the domestic political uncertainty and fragile sentiment, policy makers are likely to tread cautiously. That may add to pound weakness and potentially drive inflation back to 2009 levels of near 5 percent.

The Bank of England’s Pound and Financial Conditions  

Source: Bloomberg

In a recent speech, Fed Governor Jerome Powell outlined the cases for a “floor” and “corridor” approach to monetary policy. In a corridor system, a substantial amount of reserves would be withdrawn from the financial system, whereas a floor system would likely see $300 billion to $1 trillion of reserves maintained. The latter means less assets roll off the Fed’s balance sheet, which may keep long-term interest rates lower for longer. If a corridor system is chosen, the effective federal funds rate could at times rise above the interest on excess reserves. The Fed’s choice may fall somewhere in between the two systems. That may imply a much flatter yield curve with the possibility of inversion by 2018, a contradictory signal to current Fed policy despite very easy financial conditions.  

The Fed’s Floor and Corridor System

Source: Bloomberg

The four central bank dilemmas have something in common. They all represent opposing policy choices that lead to one result: supercharged global financial conditions that contain volatility below natural levels, flatten global sovereign yield curves, and push equity multiples to pre-crisis highs. Since there’s still significant doubt about the degree of fiscal stimulus that may come, central banks are running much looser policies that could be a precursor to a “behind the curve” situation. Bond and equity vigilantes laying low in today’s ultra-accommodative financial conditions may have their day after all.   

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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