Federal Reserve, ECB bending to markets

Fearing market disruptions, both the European Central Bank (ECB) and the Federal Reserve will most likely take more stimulus measures this month regardless of what their analyses tell them about the potential impact on the economy and financial assets. That has
implications for both future economic prosperity and medium-term financial stability, and it adds to the to-do list for policy makers and investors.
Markets expect central banks to go on a loosening tear, cutting more than 1,000 basis points in interest rates worldwide over next year. Markets have already baked this in for ECB and the Fed so heavily that a material failure by them to validate such expectations would most likely lead to a spike in volatility in financial markets, which are already nervous because of the deteriorating global economic outlook.
The best way to think of the implications is in terms of the “benefits-costs-risks” equation that Ben Bernanke, the former Fed chair, elegantly set out in August 2010 when the world’s most powerful central bank pivoted to using unconventional monetary policy for outcomes that well exceeded the narrow objective of stabilizing dysfunctional financial markets. In the current equation, relationship between central banks, economy and markets can be broken down into three main views.
In the first, central bank loosening is unlikely to do much, if anything, to boost economic activity significantly and sustainably, for two simple reasons: The cyclical and structural factors undermining growth are beyond the direct reach of central bank tools, and the use of financial assets to boost the household wealth effect and corporate animal spirits is too ineffective to move the needle materially on economic activity.
The second tempers a potentially beneficial central bank influence on the economy with growing skepticism about calming effects on financial volatility. While disagreements still linger, a growing number now also doubt ability of central banks to continue to deliver higher asset prices that decouple markets.
The third view is even more pessimistic. Building on second one, proponents worry about costs and risks of further policy loosening that has no positive economic impact. Given the high likelihood that both the ECB and Fed will adopt stimulus measures this month and beyond, policy makers need to take account of all this and redouble efforts to widen their oversight of risks, complementing their traditional focus on banks with a better monitoring of non-banks. For their part, investors should realise that they increasingly won’t be able to rely on an approach that worked so well for many years, enabling them to sidestep economic weakness: betting on central banks’ willingness and ability to repress financial volatility, boost asset prices.

—Bloomberg