Growing uncertainty about the effects of central bank tightening policies


There is a growing feeling in financial markets, reflected in media commentary, that despite all their attempts to project an air of certainty under so-called ‘forward guidance’, central banks are facing an economic and financial situation that is rapidly depleting. control.

Following the 2008 global financial crisis and again amid the market crash at the onset of the COVID-19 pandemic in March 2020, central banks, led by the US Fed, injected trillions of dollars in the global financial system to prevent a total crash.

Now they are raising rates and tightening monetary policy in the face of the highest inflation in 40 years in an attempt to suppress wage demands. But they do so under conditions never known in the past, where they have become the central pillar of the financial system.

As a result of its asset purchases, particularly over the past two years, in which it spent an additional $4.6 trillion, the Fed holds a quarter of all Treasuries outstanding and a third of all mortgage-backed securities.

The European Central Bank (ECB) and the Bank of England (BoE) hold just under 40% of their own government bonds and the Bank of Japan holds nearly half of all government debt.

The decision to tighten monetary policy by increasing interest rates and reducing these assets produces fluctuations in the financial markets, because no one really knows where it will lead.

Wall Street, which has just had its worst opening half in 50 years, is one day back in the belief that the interest rates already practiced so far are producing a recession and that the Fed will be forced to back down, only to drop the next day, when inflation figures and other economic data indicate that monetary tightening will continue.

Commodity markets also experience significant fluctuations. After climbing earlier in the year due to the US-led NATO proxy war against Russia in Ukraine, prices for many commodities have fallen sharply on fears of recession. But as the FinancialTimes noted that “even commodities that have been on a downward trajectory could soar again tomorrow.”

Currency markets are also in turmoil – an expression of the so-called smile effect which describes a situation in which the US dollar tends to rise when the US economy is growing, as well as at the other end of the world. scale when recession fears see massive amounts of money seeking so-called ‘safe haven’ in US assets.

The US dollar index, which tracks the US currency against a basket of six others, is now at its highest level in 20 years as the euro has fallen to near parity with the dollar, a level not seen before. for nearly 20 years, while the Japanese yen is at a 24-year low against the US currency.

Federal Reserve Chairman Jerome Powell (AP Photo/Susan Walsh)

While Fed officials like Chairman Jerome Powell appear to be on track for another 75 basis point interest rate hike at the end of this month, warnings are being issued about effects of monetary tightening.

On Monday, a voting member of the Fed’s policy-making body, Kansas City Federal Reserve Chair Esther George, who voted for a hike of just 50 basis points at the June meeting , said during a speech that “too rapidly changing perspective oversteer rates.

She said the current rise – the 75 basis point increase was the first since 1994 – was a “historically rapid pace” that businesses and households had to adjust to and “more abrupt changes in interest rates could create tensions, whether in the economy or financial markets”.

In a plea for greater certainty, she said communicating the trajectory of interest increases was “much more consequential” than how quickly they happened. But certainty is a very rare commodity. George said she found it “remarkable” that just four months after the rate hike began “there is more and more talk about the risk of recession, and some forecasts call for interest rate cuts as soon as next year”.

Interest rate hikes and their effects are not the only issues causing turbulence and extreme uncertainty in financial markets. A potentially bigger issue is the impact of the Fed’s decision to reduce the size of its financial assets that began this month.

The BoE and ECB have also moved to stop reinvesting maturing assets on their books and Morgan Stanley estimates the combined balance sheets of major banks will shrink by around $4 trillion by the end of the day. of 2023.

No one knows what the outcome will be because such measures have never been undertaken on this scale and the trillions of dollars injected into the final system now form the basis of the financial system.

As investment manager Guilhem Savry of Swiss financial firm Unigestion told the FT: “Liquidity is determined by central banks. For the past 10 years, there has been massive liquidity in the US and everywhere else, and now investors know it’s over. It’s finish.”

When the first steps were taken towards “quantitative tightening” (QT) in 2017, then-Federal Reserve Chair Janet Yellen said it would be uneventful and “like watching paint dry.”

It turned out to be anything but. In late 2018, after Fed Chairman Jerome Powell signaled that the Fed’s balance sheet reduction would continue on “autopilot” at the rate of $50 billion a month, Wall Street suffered its biggest drop yet. in December since 1932 during the Great Depression.

Powell turned around. Further interest rate hikes were put on hold and the Fed started cutting rates in July 2019 and asset reduction was halted. Beginning in March 2020, when the US market froze at the start of the pandemic, the Fed then bought up over $4 trillion in financial assets.

The Fed can never say publicly that the purpose of the operation was to prop up Wall Street and so the measures were framed in terms of encouraging banks and other lenders to increase their lending to businesses to promote growth. Nothing like that happened and the supply of essentially free money was used to fund the Wall Street orgy of speculation that took place in 2020 and 2021.

Today, in a context of rising inflation combined with the growing risk of recession, the question is whether this financial house of cards will collapse.

Recalling the events of 2018, a senior bond trader told the FT: “Remember it had a huge impact, and that was just on QT. There was no fear of inflation, no fear of growth like we have now.


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