With equity markets reacting enthusiastically to the Fed’s historic policy change announced last week, PIMCO’s Mohamed El-Erian notes many have rushed to declare victory. Whether in asserting investor comfort with the policy regime shift or in declaring the definitive end of dependence on quantitative easing (“QE”), they believe that the markets’ short-term reaction can indeed be extrapolated into the longer-term. While most Fed officials will welcome the markets’ favourable reaction – and especially so after the May-June shock – El-Erian suspects that they are much more cautious. Indeed, in this FT Op-Ed, he lays out four reasons why such caution is understandable.
Via The FT,
First, the impact of Fed policy remains overly dependent on using artificially-high asset prices to alter household and company economic behaviour. Other transmission mechanisms, including the credit channel and the deployment of cash in real economic investments, remain muted. Accordingly, concerns about financial soundness will persist until the Fed witnesses improving economic fundamentals that validate artificially-elevated asset prices.
Second, the Fed is entering a more uncertain policy phase due to its ongoing instrument pivot – namely, less reliance on a direct measure (monthly purchases) and greater reliance on an indirect one (impacting behaviour through forward policy signals). Issues regarding the degree of effectiveness and control could well come to the fore. Just witness the recent sharp upward moves in the 5-year US Treasury yields, along with other intermediate maturities.
Third, those at the Fed who follow closely market positioning will probably recognise that equity markets are currently in the grips of very favourable technicals; and, judging from history, such technicals can lead to price overshoots whose reversal can be quite disruptive.
Finally, the Fed is not the only central bank that has been active in maintaining economic and financial tranquility and, to this end, continuously bolstering asset prices; and it is not the only institution that has been forced to rely on imperfect instruments to fulfil this task.
The European Central Bank and the Bank of Japan are in the same boat. And they, too, face tricky policy issues ahead, with success also ultimately dependent on the overall ability of their economies to overcome the trio of inadequate aggregate demand, insufficient supply responsiveness and residual debt overhangs.
After a couple of false starts, Fed officials have impressively won the first big battle in implementing a gradual orderly exit from QE3, a highly-experimental measure whose longer-term consequences are not fully known as yet. They are yet to win the war.
Of course, a glance around the world – from Turkey to Thailand and even in credit and volatility markets in the last few days, and perhaps El-Erian’s caution is warranted.