Fearing market disruptions, both the European Central Bank and the Federal Reserve will most likely take more stimulus measures this month regardless of what their analyses tell them about the potential impact on the economy and financial assets. That has implications for both future economic prosperity and medium-term financial stability, and it adds to the to-do list for policymakers and investors.
Markets expect central banks — not just in advanced economies but also in emerging markets — to go on a loosening tear, cutting more than 1,000 basis points in interest rates worldwide over the next year. Markets have already baked this in for the ECB and the Fed so heavily that a material failure by them to validate such expectations would most likely lead to a spike in volatility in financial markets, which are already nervous because of the deteriorating global economic outlook.
Hoping to keep the risk of such volatility from undermining household and corporate sentiment, these two central banks will feel compelled to loosen monetary policy further, first on September 12, with the ECB cutting its rates further into negative territory and resuming asset purchases, and then on September 18, with the Fed cutting interest rates again.
Will cuts help?
The best way to think of the implications is in terms of the “benefits-costs-risks” equation that Ben Bernanke, the former Fed chair, elegantly set out in August 2010 when the world’s most powerful central bank pivoted to using unconventional monetary policy for outcomes that well exceeded the narrow objective of stabilising dysfunctional financial markets. In the current equation, the relationship between central banks, the economy and markets can be broken down into three main views.
In the first — which the majority of economists and market participants now adhere to — central bank loosening is unlikely to do much, if anything, to boost economic activity significantly and sustainably, for two simple reasons: The cyclical and structural factors undermining growth are beyond the direct reach of central bank tools, and the use of financial assets to boost the household wealth effect and corporate animal spirits is too ineffective to move the needle materially on economic activity. (And let’s not forget the handful of economists who think that domestic economic conditions do not warrant a US interest rate cut now or quantitative easing in Europe.)
Not as influential
The second, while not as uniform, tempers a potentially beneficial central bank influence on the economy with growing scepticism about the calming effects on financial volatility. While disagreements still linger, a growing number now also doubt the ability of central banks to continue to deliver higher asset prices that decouple markets even more from underlying fundamentals.
This comes in stark contrast to what had been an almost universal faith in the ability of central banks to remain the markets’ BFF. As such, there is less enthusiasm among investors and traders for buying market dips ahead of central bank loosening.
The third view is even more pessimistic. Building on the second one, proponents worry about the costs and risks of further policy loosening that has no positive economic impact. This includes fuelling irresponsible risk-taking — particularly outside the banking sector — as well as eroding institutional credibility and using measures that would be needed were the US to stumble into a recession.
Given the high likelihood that both the ECB and Fed will adopt stimulus measures this month and beyond, policymakers need to take account of all this and redouble efforts to widen their oversight of risks, complementing their traditional focus on banks with a better monitoring of non-banks. For their part, investors should realise that they increasingly won’t be able to rely on an approach that has worked so well for many years, enabling them to sidestep economic weakness: betting on central banks’ willingness and ability to repress financial volatility and boost asset prices.
Mohamed A. El-Erian is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens’ College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include ‘The Only Game in Town’ and ‘When Markets Collide.’