We’ve entered a danger zone in central banking
Policy decisions by some of the world’s leading central banks are undermining confidence and fueling volatility in markets
For investors anxiously looking to central banks for reassurance amid the plethora of risks and vulnerabilities facing the global economy, this week’s policy meetings of the US Federal Reserve and the Bank of Japan (BoJ) are proving to be something of a disappointment.
While the Fed and the BoJ are moving in opposite directions - the US central bank raised interest rates in December andis now debating when to undertake a second rate hikewhile the BoJ is implementing a programme of aggressive quantitative easing (QE) - their policies have failed to live up to the expectations of investors.
A combination of patchy US economic data in the first-half of this year, a series of worrying global developments ranging from the fallout from China’s economic slowdown to British voters’ decision to leave the European Union (EU) and, most importantly, the diminishing effectiveness and perverse consequences of central banks’ actions have turned monetary policy into a major source of volatility for markets.
The uncertainty is fuelled by investors’ belated, albeit grudging, recognition that central banks cannot and should not be, as the prominent economic adviser Mohamed El-Erian describes them, “the only game in town”.
As the International Monetary Fund (IMF) rightly noted in its economic update last week: “the effectiveness of [monetary] policy support would be enhanced by exploiting synergies among a range of policy tools, without leaving the entire [financial] stabilisation burden on the shoulders of central banks.”
Unfortunately, politicians the world over are reluctant to provide the necessary support, either because of opposition to structural reforms from vested interests or because of disagreements among politicians themselves about what needs to be done to restore investor confidence and underpin growth.
For the Fed, the conduct of monetary policy has become more challenging over the past year because of the growing importance of international developments in the central bank’s deliberations over the timing of its next rate increase.
On Wednesday, the US central bank injected yet more uncertainty into markets by leaving open the possibility that it could tighten policy as early as September as a result of diminishing risks to its economic outlook.
Yet investors, who have grown accustomed to the Fed’s inconsistent and confusing messages, chose to ignore its hawkish hint of an earlier-than-expected tightening, with the yields on Treasury bonds declining slightly after the Fed’s announcement.
The Fed has wrong-footed investors so many times that markets are betting it will turn more dovish once again.
Yet it is the BoJ which has let down investors the most, partly because of the central bank’s poor communication skills.
Ever since Japan’s central bank stunned investors on January 29 by imposing negative rates – a move the BoJ’s enigmatic governor, Haruhiko Kuroda, had virtually ruled out only a week before – markets have become increasingly frustrated by its unpredictable monetary policies. This has contributed to an 11 per cent rise in the yen against the dollar since late January, precisely the opposite of what the central bank intended with its negative rate policy.
Indeed the yen has fluctuated wildly in the run-up to Friday’s BoJ meeting partly because of fears that Kuroda will underwhelm. Japan’s currency, moreover, has stopped reflecting the country’s ultra-loose monetary conditions and has reasserted its role as a “haven” asset in times of market uncertainty. “Even if one knew what the BoJ was going to do [on Friday], there is not much confidence in anticipating the yen’s direction,” notes Brown Brothers Harriman.
Yet at least the burden of policy accommodation in Japan is shifting from the central bank to premier Shinzo Abe’s government - which is more than one can say about the policy response in Europe where Germany is opposed to any major fiscal stimulus package.
All eyes are on the size and duration of Tokyo’s fiscal stimulus package which is set to be approved by the government next week. On Wednesday, Abe was reported to be planning an aggressive ¥28 trillion stimulus plan, with fiscal easing measures accounting for half of the boost. This provided a fillip to Japanese stocks and put downward pressure on the yen.
Yet the scope for disappointment is considerable.
With very limited fiscal space - Japan is already running a huge budget deficit and has the world’s biggest public debt burden as a share of GDP - the amount of real new spending is likely to be limited, heaping yet more pressure on the BoJ.
Stimulus-hungry investors should brace themselves for yet more volatility in the coming days.
Nicholas Spiro is a partner with Lauressa Advisory