Fed’s No-Win: Balancing Growth and Market Fragility

(Bloomberg Opinion) -- Resisting unusual pressure from both politicians and notable market participants, Federal Reserve Chairman Jerome Powell and his colleagues on the Open Market Committee on Wednesday raised interest rates by 25 basis points and slowed the path for future hikes by less than markets hoped.

In doing so, the central bank reaffirmed that its focus remains firmly domestic and economic. But the markets’ reaction suggested the move was seen as heightening concerns about a policy mistake, rather than responsible policy making. This, and what’s likely to play out over the next few weeks, illustrates a bigger phenomenon: the threat that the Fed and other central banks are increasingly in a no-win situation, due to factors mostly outside their control.

The Fed’s updated economic assessment is somewhat less rosy than those it made before, and includes a slight downward revision in next year’s gross domestic product. Still, policy makers seem less concerned than markets about the spillbacks to domestic consumption and investment from weakness in the rest of the world and technically vulnerable asset prices. For that reason, the central banks’ median expectation for next year’s rate hikes is still well above the markets’, and policy makers remain comfortable with the notion that they could slightly overshoot the neutral rate estimate in 2020. Although these predictions are described as highly data-dependent, as is customary for the central bank, they unsettled markets across the board.

At first, the reaction of high-frequency market indicators fluctuated between “It’s OK” and “It’s not a sufficiently dovish hike.” But as markets internalized more fully the Fed announcements, they tipped in favor of the view that the central bank risks a policy mistake. Those concerns were reflected in a broad-based stock market sell-off, a lower 10-year Treasury yield, and a flatter yield curve. That outcome is hard to reconcile with what remains a rather solid economic outlook for the U.S.

This dichotomy between an economy that is expanding at a robust pace and volatile markets that are coming under further pressure is the main reason why this Fed meeting was preceded by such uncertainty about outcomes, together with a heated debate that has not been seen for years. The split is in large part the mirror image of the situation faced by Powell’s predecessors when sluggish growth contrasted with booming risk markets. But rather than providing proof of a decoupling of the economy and markets, the change is in fact a partial closing of the gap that was created under former Fed chairs.

For several years after the 2008 global financial crisis, the U.S. economy was stuck in a new normal of low growth, soaring asset markets, and dampened financial volatility. This was due in large part to the decision of systemically important central banks to pursue their economic objectives through the asset channel: ultra-low interest rates and securities purchases as a means of encouraging risk-taking, triggering households’ wealth effect and encouraging higher business investment. China-driven global growth also contributed to asset-price inflation and volatility repression, as emerging-market stocks outpaced their U.S. counterparts.

Some, including me,  expressed concerns about the risks and unintended consequences of central banks continuously “goosing” markets. But these cautions gained little traction, for understandable reasons. After all, central banks were motivated by noble economic objectives whose importance was accentuated by how close the world had come to a multiyear global depression, a threat that imparted a bias to policy makers’ risk-management paradigm. And let’s not forget that an environment in which almost all assets made money for investors doesn’t provoke much resistance and complaint.

Now the situation is reversed: A still-solid U.S. economy isn’t sufficient to dampen financial volatility and resist price declines in the context of structural market fragilities. This is due to five main factors:

• The outlook for Europe, Japan and China is considerably more uncertain than the prospects for the U.S.

• Markets also have to adjust to losing the predictable and ample liquidity support they received from the European Central Bank. 

• The proliferation of exchange-traded funds, passive investing, computer trading and excessive risk-taking amplify price moves.

• The Powell Fed inherited a balance-sheet policy on automatic pilot that tends to exaggerate the market impact of any change in interest-rate expectations.

• The Fed is facing unusual political pressure not to raise rates.

While the U.S. central bank faces a more challenging environment, it is in a far less complex situation than its systemically important peers, particularly the ECB, the Bank of England and the Bank of Japan. A notably weaker economic outlook in those regions significantly undermines a policy-normalization process that has become more urgent due not only to declining effectiveness but also operational limitations (for example, the ECB running out of bonds to buy) and unintended consequences.

It has become customary for new central bank chiefs to be tested early in their tenure. In Powell’s case, the challenge has taken the form of a controversial policy decision due to the competing pull of domestic economic conditions and the combination of technical market fragility and a slowing international economy. This tug-of-war is unlikely to end any time soon. As a result, central banks that were once the only game in town, celebrated for their dominant “whatever-it-takes” policy mindset that reduced the risk of a multiyear depression, now operate in much more of a “lose-lose” environment, and for reasons that are mostly outside their control.

My 2016 book, “The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse,” warned about the risks to future financial and economic stability of excessive protracted reliance on unconventional monetary policies, together with collateral damage to sociopolitical and institutional structures, including the independence and credibility of central banks.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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. His books include “The Only Game in Town” and “When Markets Collide.”

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