Central Banks’ ‘Embrace’ of Markets May Be Complicating Policy

(Bloomberg) -- The Bank for International Settlements cited recent volatility as another instance of the “extraordinarily tight” relationship between policy makers and financial markets that it has questioned in the past.

Economics chief Claudio Borio said the linkages in part explain the Federal Reserve’s decision to put interest-rate hikes on hold. He doesn’t criticize the decision, and notes the slowdown in the global economy, but also says that as “central banks and financial markets dance locked in this embrace, it is sometimes hard to tell their steps apart.”

“Financial markets scrutinize central banks’ every word and deed, taking them as the cue for their ups and downs and seeking perennial comfort. Central banks, in turn, scrutinize financial markets to better understand what the future holds for the economy, as markets both reflect and influence activity -- a complex and delicate task.” BIS Quarterly Review

The Basel-based institution has previously raised issue with forward guidance, which came into vogue during the financial crisis and involves policy makers stating an expected course of action so as not to surprise investors.

BIS Economic Adviser Hyun Song Shin argued in 2017 that institutions telegraphing their actions risk winding up with an “echo chamber of their own making, acting on market signals that are echoes of their own pronouncements.”

That may have been the case in December, when concern about the Fed’s perceived preset tightening course hit global stocks. The central bank subsequently eased off on rate hikes, helping a market rebound. Chairman Jerome Powell said Feb. 27 that officials take account of market volatility if it threatens the broader economy.

Former Reserve Bank of India Governor Raghuram Rajan said earlier this year that it would be good if markets didn’t “continuously rely on central banks to come to the rescue.” While concerns about economic growth “rightfully” made the Fed more tentative, he sees disentangling policy from market behavior as one of the biggest challenges.

Under General Manager Agustin Carstens, the BIS has previously warned that policy makers face a “narrow” path as they normalize monetary policy after years of crisis fighting. With the Fed on pause and the ECB’s planned tightening likely to be pushed back, it said Tuesday that the job is getting even harder.

“The gradual and predictable monetary tightening process is on pause and has become less predictable,” the BIS said. “The narrow normalization path is proving to be a winding one.”

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