Pursuit of unconventional monetary policy may be in the market's hands
The pursuit of forward guidance from central banks raises concern over financial stability risks as monetary policymakers fear upsetting markets
Don't fight the Fed was once a maxim for investors to live by and shorthand for the unwritten rule that when the world's major central banks demanded that markets jump, the only response was "How high?"
But the pursuit of unconventional monetary policy - and, more recently, forward guidance - designed to shore up market confidence in the wake of the global financial crisis may not simply have dulled the power of the central banks but effectively transferred it to the markets.
That is the conclusion of a provocative new paper from the Bank for International Settlements, the central bankers' bank.
In an article entitled "Forward guidance at the zero lower bound", economists Andrew Filardo and Boris Hofmann throw the perils of forward guidance policies - communicating that interest rates will remain low for longer than is priced into markets - into sharp relief.
They warn such policies "can indirectly create financial stability risks if monetary policy becomes increasingly concerned about adverse market reactions", possibly resulting in "an undue delay in the speed of policy normalisation and the risk of an unhealthy accumulation of financial imbalances".
In other words, not only may investors be underpricing risks in the capital markets because of expectations that central banks will signal interest rate rises way in advance, but central banks themselves may be afraid of tightening monetary policy for fear of spooking markets.
If this is the case, the market tail is wagging the central bank dog.
The recent difficulties faced by the United States Federal Reserve in exiting its programme of quantitative easing are particularly revealing.
No sooner did the Fed signal its plans last year to gently begin scaling back or "tapering" its asset purchases than the yield on benchmark 10-year US treasuries surged, from 1.6 per cent in May to 3 per cent in September, causing emerging market assets to sell off dramatically.
The Fed had to spend much of the second half of last year trying to put as much clear blue water between its intention to start withdrawing liquidity and its determination to keep interest rates low until such time as the US economic recovery is sufficiently advanced.
Still, the credibility of US monetary policy suffered significantly, especially after the Fed stunned markets in September by deciding to postpone the taper.
This unsettled investors further and revealed deep misgivings on the part of those on the Fed's policymaking committee who believed putting off the taper could "undermine the credibility or predictability of monetary policy".
In October, Jaime Caruana, the general manager of the BIS, said in Mexico that central banks "need to have a thick skin when facing the [threat] of financial dominance".
Effectively, Caruana flagged the potential loss of central banks' operational independence as a result of intense pressure from markets.
Yet it would be wrong to focus solely on the role of monetary policy in maintaining investor confidence and fostering the global economic recovery.
Central banks' ultra-loose monetary policies were undertaken to help shore up recession-stricken economies and in the face of repeated failures by politicians to implement much-needed fiscal, structural and governance reforms - particularly in the case of the euro zone and the US.
As Caruana pointed out, the world's leading central banks have become overburdened, giving rise to a widening gap between what they are expected to deliver and what they can actually deliver.
One of the redeeming aspects of the recent emerging market sell-off is that it has forced markets to pay more attention to country-specific risk.
While it was the unexpected shift in Fed policy that triggered a belated repricing of risk in emerging markets, the recent phase of the sell-off has had much more to do with concerns about the credibility of policymaking regimes in those markets and the implications they have for economic growth.
From the perspective of the Fed, which has made it clear that its actions will be determined solely by developments in the US economy, to the dismay of emerging markets' policymakers, investors' willingness to distinguish more clearly between developing economies with strong fundamentals and those with weak ones is to be welcomed.
In the Fed's eyes, last summer's "taper tantrum" has helped narrow the gap between developing countries' borrowing costs and their underlying fundamentals as markets begin to price risk more accurately.
Still, it is worrying that the mere hint of a small reduction in the Fed's asset purchases wreaked such havoc - especially as there is still a much longer way to go before there is an actual rise in US interest rates.
That underscores the challenge central banks have given themselves in guiding markets effectively.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy