Macroscope | Why a mistake by the Fed will make it harder for Asia to cut rates

Initially, markets treated the Fed’s dovish pivot as a clear sign rates had peaked and were about to come down sharply. Futures markets are still pricing in 1.4 percentage points worth of easing this year, with around a 50 per cent probability of a reduction as early as March.

The results of Bank of America’s latest global fund manager survey, published this week, revealed that expectations for lower borrowing costs reached their highest level since the poll began. Respondents were also optimistic about the odds of a “soft landing” for the global economy.

Yet, since the start of this year, doubts have crept in about the Fed’s ability and willingness to loosen policy significantly. The uncertainty stems from deeper concerns about a costly policy mistake, either due to a premature easing of policy or a belated one. In the Bank of America survey, 24 per cent of respondents believed the biggest “tail risk” in markets was a hard landing while 21 per cent said the main threat was higher-than-expected inflation.

Blunders committed by two previous central bankers loom large in the minds of many investors. By far the most egregious policy mistake was the failure of Arthur Burns, the chairman of the Fed for most of the 1970s, to keep rates high enough for long enough. This allowed inflation to slip out of control, forcing his successor, Paul Volcker, to raise rates much more aggressively at the cost of inducing a severe recession.

Another colossal error of judgment was the decision by Jean-Claude Trichet, the former president of the European Central Bank, to raise rates in 2008 and 2011 – just before the collapse of Lehman Brothers almost brought down the global financial system, and later on when the euro-zone debt crisis was escalating – despite severe economic and financial strains in the euro zone.