Once again, markets will pay close attention to signals from the US Federal Reserve’s Open Market Committee, which meets this week.
Coming on the heels of a dramatic two-month rollercoaster – as the S&P 500 fell 6 per cent between May 21 and June 24 before recovering to finish last week near its record high – the scope for misinterpretation is far from trivial. So here are seven points investors may wish to keep in mind as they navigate yet another fluid policy phase.
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The Fed has no choice but to operate through financial markets to achieve its mandated economic objectives. The central bank’s exceptional support of markets is a means to an end, and not an end in itself. And in a world where polarised politics sideline most other policy-making entities, higher asset prices are virtually the only mechanism available to promote growth and jobs.
The Fed is resorting to three tools to bring forward growth via beneficial wealth effects and invigorated animal spirits. Of the three – flooring policy interest rates at negative real levels for an exceptionally long time, providing aggressive forward policy guidance, and expanding the balance sheet via security purchases – only the latter two are in play.
Policy rates are not going anywhere for quite a while. Sluggish growth, low inflation and large excess bank reserves preclude the Fed from raising rates; and while markets have a tendency to forget this, a floored policy rate imposes downward pressure on short-to-intermediate market interest rates.
Forward policy guidance will evolve further as Fed officials experiment with ways to better connect expectations and economic objectives. In its quest for better “communication”, the Fed has progressed from specific calendar guidance to conditional economic outcomes. Yet results continue to disappoint, with an economy stuck in a liquidity trap and challenged by inadequate demand, structural headwinds, pockets of debt overhang and insufficient policy co-ordination. Moreover, the Fed cannot ignore the risks still facing Europe and the slowdown in systemically important emerging countries.
The Fed’s inclination to taper its balance sheet purchases is motivated by more than an optimistic view of the economy. While this may (and, I suspect, will) change in light of a disappointing second-quarter outcome and sluggish momentum into the third quarter, the Fed retains relatively optimistic 2013 growth projections. Some officials are also concerned about the potential collateral damage and unintended consequences of imposing experimental monetary policy on a sophisticated market economy for such a long time.
The Fed’s inclination to taper its balance sheet purchases is motivated by more than an optimistic view of the economy
The path forward is fraught with expectation-formation challenges. Most importantly, the natural desire of economists (and most Fed officials) for a well-telegraphed policy journey – thus minimising the scope for disorderly shocks – competes with the reality of investors seeking to price the final destination. This was certainly a lesson from the May/June market disruptions: with investors jumping quickly to perceived terminal values, Fed officials felt compelled to “talk back” their taper message.
The functioning of financial markets is less robust than many previously believed. This was another May/June lesson. Sudden price falls were accompanied by discomfiting changes in correlations, a worrying erosion of market liquidity, reduced intermediation capacity, and significant outflows – all of which threatened to undermine economic activity. Meanwhile, to the extent that Fed governor Jeremy Stein was correct in worrying about excessive market exuberance that could spell trouble down the road, the result of the markets’ two-month round trip could be quite disconcerting for the Fed: risk markets recovered from the sell-off while “risk free” assets did not.
The danger is that the wrong side prevails in what is proving to be an epic and historic policy tug-of-war
Given the extent to which investors have relied in recent years on the exceptional support of central banks, these seven factors speak to an asset price outlook that is inevitably full of unusual outright uncertainty (and not just the usual array of risk factors).
The hope is that this will be eventually nullified by a steady improvement in the outlook for economic fundamentals. By delivering incremental growth and validating prices for risk assets, this would enable the removal of the “Fed put” without unduly disrupting markets and the economy.
The danger is that the wrong side prevails in what is proving to be an epic and historic policy tug-of-war. Rather than a decisive win by economic fundamentals, the contest would end up being dominated by imperfect Fed policy tools that become increasingly ineffective at compensating for the lack of support from other policy-making entities.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco