Central banks no longer cushion economies, markets

If governments, companies and markets needed any further reminders that their operating environment is changing, they got it last week. Despite weakening economic momentum and volatile financial markets, a second systemically important central bank, the European Central Bank (ECB), reiterated its intention to stop using large liquidity injections to support economic activity and asset prices. The change in this ‘global factor’ is translating into a volatility “regime change” in markets, requires an evolution in investment strategies, and calls for compensating pro-growth policy measures on the part of many individual countries.
The ECB’s October 25 announcement that its governing council still intends to stop large-scale asset purchases, known as quantitative easing or QE, at the end of the year occurred in the context of what central bankers acknowledge is an increasing list of threats to their economies. At a news conference after the central bank’s policy meeting, ECB President Mario Draghi said the risks include an uncertain trade regime, pressures in emerging markets, politics and the budgetary confrontation between Italy and the European Union. And by stating that the “ECB mandate does not involve financing government’s deficit,” Draghi emphasised the implicit message that neither governments nor markets can continue to rely on regular, large and predictable liquidity injections to offset their own problems.
The ECB’s signals reinforce those that the Federal Reserve has been sending for a while now. Despite weakness in housing, an historical indicator of cyclical trends for the US economy, and notwithstanding complaints by President Donald Trump, top Fed officials continue to leave no doubt of their intention to further hike interest rates while reducing the bank’s balance sheet.
The increase in market instability should come as no surprise. It was clear from early in this exceptional monetary-policy phase that central banks’ “unconventional policies” were aimed at repressing volatility as a means of promoting economic activity. Also, central banks have been consistent and clear about their intentions to exit this phase as economic conditions allow.
The resulting journey away from the prolonged implementation of unconventional policies inherently involves more financial and economic volatility. This is especially true given how much market participants have downplayed liquidity risk in certain segments and how many governments have been slow in implementing pro-growth structural reforms.
Pockets of excessive risk-taking that emerged during the prior period of ample liquidity and the extent to which certain governments and corporates used the period of unusually low interest rates to pile on too much debt and allow excessive currency mismatches to emerge.
The message to governments, corporates and market participants is clear: Central banks are dead serious about getting out of the business of suppressing volatility, and the process could be approaching critical mass.
Economic actors and market participants need to get ready for greater environmental instability as monetary policy transitions away from unusual and experimental measures to historically more recognisable ones. This change has the potential to place both the global economy and markets on a more solid fundamentally based foundation over the longer-term.
But it also requires timely adaptations in both or the possibility of the better could give way to the agony of the worse.

—Bloomberg

Mohamed A. El-Erian is a Bloomberg Opinion columnist
. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO