Who's afraid of the central banks?
This year will bring a further withdrawal of the easy-money policies that have helped to shape markets and economies since the global financial crisis. The U.S. Federal Reserve, after raising rates three times in 2017, is signaling more increases and has started to reduce the size of its balance sheet gradually; the European Central Bank will pare back the pace of its bond purchases.
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All of that might be a big cause for concern if it were happening in a vacuum. But for investors to focus on central banks alone might be a mistake.
After all, the monetary supertanker has been on the turn for a while. The Fed first raised rates in the current tightening cycle at the end of 2015; the ECB already made a modest reduction in its asset purchases at the start of 2017. Yet there has been nothing like the so-called taper tantrum of 2013, which sent global markets into turmoil. By contrast, markets have taken central-bank actions of late in their stride.
There are some good reasons for that. The first and most important is the cyclical, synchronized recovery in global growth that characterized 2017. The global manufacturing purchasing managers index was near a seven-year high in December, at 54.5; subindexes for output, new orders, new exports, employment, prices and future output all pointed to expansion, too. Indeed, 2017 was the first year since 2010 when advanced and emerging economies accelerated in tandem on the International Monetary Fund's numbers. And outside the U.S., the economic cycle is less advanced, meaning there is clearly still room for the cyclical recovery to continue.
Another important factor in the prevailing calm in global markets is the extreme caution that central banks are employing both in communicating and taking actions. The Fed, for instance, is raising interest rates at a snail's pace. It has taken two years since December 2015 for the Fed to lift rates a total of 1.25 percentage points, or 0.05 point a month. That compares with an average 0.18 point a month in the previous tightening cycles since 1983, making this the slowest-moving shift in policy in four decades, JPMorgan Chase notes.
Real interest rates -- adjusted for inflation -- are extremely low. The rise in inflation from its nadir in 2015 and 2016 has eased a key source of pressure on central banks. The problem was that as inflation fell, real interest rates rose: A challenge that had previously only emerged in Japan thus became a global issue, most notably in the eurozone.
But 2017 saw inflation pick up, albeit to levels that still fall short of where central banks would feel comfortable. The upward pressure on real rates has thus receded. As a result, in the U.S., very short-term real rates are negative; in the eurozone, the ECB's negative-interest-rate policy, with banks charged 0.4% for keeping cash in the central bank's deposit facility, has become even more negative in real terms. And the ECB has started to emphasize that its bond purchases are just part of a package that is aimed at keeping monetary conditions loose. Negative interest rates may yet turn out to be more powerful than appreciated, due to their persistence.
The key swing factor is still inflation. In 2017, financial markets had the best of all worlds: Growth was decent, but inflation was well-behaved. The real vulnerability for markets now is a sudden, sharp rise in inflation that causes central banks to act with much more urgency not only to withdraw stimulus but to tighten policy actively. The U.S. economy and the Fed are clearly on the front line of that battle, as the recovery is well advanced. But elsewhere, central bankers are still likely to err on the side of caution.
In the absence of a clear pickup in inflation, bond yields may struggle to rise. It is not only central bank policy that has held yields low: Regulation that favors banks holding "safe" assets like government bonds and a continued search for income-generating assets have played their part, too. The modest rise in yields since 2016 has had few visible effects on the economy. Indeed, low long-term yields actually became a source of concern in 2017. The narrowing gap between two- and 10-year U.S. Treasury yields has had some investors worried that it is signaling an economic slowdown ahead.
Ultimately, there is a subtle but important shift occurring in the role of monetary policy. For a while after the crisis, central banks were the single source of support for economies and markets. That led to their taking an unusual turn in the spotlight, when they more usually set the backdrop against which other economic actors -- individuals, companies and governments -- shape the path of the economy. The language being used by some central bankers is shifting. ECB President Mario Draghi in December spoke of monetary policy now "accompanying the expansion." That implies providing continued support, but not taking center stage.
Investors have to pay attention to central banks, of course. But they are no longer the only game in town.
Mr. Barley, a Wall Street Journal reporter, is based in London and a columnist for Heard on the Street. He can be reached at email@example.com.
(END) Dow Jones Newswires
January 22, 2018 15:32 ET (20:32 GMT)
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