Give financial markets what they wish for, and they will ask for more. Give them more than they wish for and they’ll still ask for more. Just ask Fed chairman Jerome Powell.
His remarks to US Congress on Wednesday were more dovish than expected, but rather than strengthening the Fed’s effectiveness and easing the political and social pressures on it, this could aggravate the risk of a lose-lose outcome for the world’s most powerful central banks.
Powell’s remarks did more than solidify expectations that the Fed would cut interest rates by 25 basis points later this month. It also empowered a growing number of market participants to call for, and expect, a 50-basis-point cut.
And all this at a time when the unemployment rate is at a five-decade low, financial conditions are the loosest for over two decades, market interest rates are at historically-low levels, stock prices are elevated and, to use Powell’s own words, the US economy is in a good place.
Given the Fed’s systemically important role, the institution’s more dovish policy guidance is seen, correctly, as also opening the way for looser monetary policies by many other central banks around the world. With that, investors’ initial reaction was to trigger a “buy everything” rally.
There are downsides to this so-called Fed put: The more it is used, the higher the risk of unfortunate spillover effects for economic, financial, political, social and institutional conditions.
What is liked by financial markets is unlikely to translate into a material improvement in either of the two variables that the Fed pursues under its mandated objectives — low unemployment and manageable inflation — and the further decoupling of elevated asset prices from fundamentals increases the risk of financial instability down the road.
All this is intimately related to how perceptions of the put have evolved over the last 10 years. The initial 2008-09 “Bernanke put” under the former chairman was seen as aimed at normalising what were, at that time, highly dysfunctional markets that threatened sever damage to the economy. The Yellen put that followed was much more about buying time for the economy in the hope that the deeply polarised politics would improve and enable a more comprehensive policy response involving a lot more than exceptional monetary measures.
This has now morphed into the current Powell put, which increasingly fuels perceptions that the Fed is now held captive by markets, having to tilt ever more dovish regardless of financial conditions that are already ultra loose, a solid domestic economy and limited evidence that the Fed is able to materially improve economic conditions at this stage of the economic cycle.
I have been very interested in the cost-benefit of central banks having become the “only game in town” policy-wise. My 2016 book analysed how the protracted over-reliance on central banks entails considerable long-term risks to both economic well-being and the future effectiveness of these important policymaking institutions.
Developments since then suggest that these risks are becoming both more important and more front-loaded.
Mostly because of structural challenges and the highly unbalanced policy mix, it is hard to see how lower interest rate would help boost economic activity and raise inflation to the Fed’s 2 per cent objectives. Yet, having been conditioned by years of liquidity-driven rallies fuelled by central banks, it’s not hard to understand why expectations of such cuts push already-elevated asset prices higher.
And especially so given that markets also expect other systemically important central banks to loosen their monetary policies, including the ECB restarting its large-scale asset purchase program while also cutting rates further into negative territory. Some are even talking about the possibility, as absurd as this sounds, of the more highly rated segments of the junk bond market potentially trading at near-zero or even negative yields.
This is not to say that there should be no policy response. One is needed to generate more inclusive growth, but it has to involve structural policies aimed at lifting existing impediments, a more conducive environment for the fast-changing drivers of economic activity and, where there is fiscal space, a more active use of budgetary policies.
Instead, continued excessive reliance on monetary policy is risky. In the short term, imposing the bulk of the economic policy burden on central banks risks either not delivering on the markets’ inflated expectations or delivering and then suffering credibility damage because the economy is already so strong and further monetary loosening is unlikely to do much.
Over the longer term, it increases the risk of future financial instability because, when conditions become more challenging, central banks will have already used so many of their tools during the good times. All of this would expose central banks to greater political and social pressures, and greater institutional damage.