The negative market reaction in developed markets to the decision of the US Federal Reserve to maintain the status quo and keep policy rates near the zero bound is quite telling and counter-intuitive.
While Fed chief Janet Yellen’s policy decision was on expected lines, her tone when referring to the threats posed by global factors, especially China, were quite a mood dampener. Clearly, the new reaction assigns a greater weight to global financial market developments.
The last time international factors stopped the US Fed from hiking rates was in 1997-1998 when the Asian financial crisis, Russia’s default and the fall of long-term capital management (LTCM) posed serious global systemic risks.
Her positive remarks about the health of the US economy were largely overshadowed by constant references to developments in China and emerging markets posing significant threats to the global economy. One would have to view last Thursday’s Federal Open Market Committee (FOMC) meet as highly dovish and accommodative.
The fact is that the markets, especially in the developed world, want to see a US monetary normalisation as soon as possible. Keeping rates at or near emergency situation levels made sense during much of the last seven years, but don’t do so now.
Quantitative Easing (QE) measures were initially a response to prevent the financial system from falling off the cliff during the peak of the credit crisis but soon turned into instruments to simulate the real economy. The debate is still on within academics as to how effective these measures were and many blame QE for a further rise in inequality in advanced economies.
But to the extent that the unemployment rate has halved since its peak in the US, housing prices have stabilized largely due to the wealth effect created by booming stock prices fuelled by cheap liquidity and there has not been runaway inflation as many warned back in 2008-QE in the US should be labeled as successful.
But it is also true that QE exhibits the law of diminishing returns — QE 1 was more effective than QE 2, which in turn was more effective than “operation twist” and QE 3. This was in terms of their effect on the real economy. The markets however cheered each round of QE with equal if not more enthusiasm. The classic risk on move was: Bad data implies more QE implies higher asset prices.
Now things are all set to change. US bulls are aware that the monetary normalization undertaken by the Fed will be accommodative and data dependent. But from now onwards, any major disappointment on the economic data front which signals that the US Fed has to backtrack and consider cutting rates again will not be met by cheers. Risk on now means: moderate/good data implies moderate rate hikes over the coming years implies higher asset prices.
If this is not the case, then the trust over the efficacy of easy money central bank policies will be completely broken. The cue will be taken from the US Fed. The same policies have been adopted by the Bank of England which is also looking at raising rates in early to mid 2016.
The European Central Bank (ECB) and the Bank of Japan (BoJ) are also in QE mode and there are expectations of more easing from both these institutions in the coming months. Thus, if US monetary normalization fails, it naturally implies that the goals of the ECB and the BoJ QE will most likely not be met.
What ammunition will central banks have left? Moving to negative interest rates will be one option. But the underlying investor psychology will still remain the same: central banks have no more firepower left. We are entering an era where the financial headlines will read “QE sends markets tumbling”.