When Will Monetary Tightening Hit Financial Conditions?
(Bloomberg Opinion) -- There is little doubt that advanced countries in the first half of 2022 will pull back, albeit partially, on the ultra-stimulative monetary policies they have pursued for several years. What is more consequential, yet less certain, is when and how this will lead to a meaningful tightening of financial conditions and what the spillover effects will be for the global economy. These issues are of interest not only to policy makers around the world but to businesses, households and investors as well.
Already, expectations have changed drastically for U.S. monetary policy. Less than two months after Federal Reserve Chair Jerome Powell “retired” the “transitory” characterization of inflation, consensus for this year has shifted to include the end of large-scale asset purchases, at least three interest rate increases starting in March and the initiation of shrinking the central bank’s balance sheet.
This change has come in the context of high and persistent inflation, including a 7% reading for the U.S. consumer price index for December, and what some, such as BlackRock’s Rick Rieder, call a “red hot” labor market. It has intensified in the past two weeks despite the increase in Covid-19 omicron cases, a slowdown in China’s economy and downside revisions to global growth projections, including by the World Bank.
A few other developed countries, such as the U.K., are more advanced than the U.S. in reducing exceptional monetary policy stimulus. It is only a matter of time until others join the fray.
While interest rates have started to move higher, this notable change in monetary policy has not yet led to a significant tightening in overall financial conditions. Consequently, the real economy has not yet felt any contractionary impulses, markets have been relatively sanguine, and developing countries have experienced few disruptive spillovers.
Several reasons have been proposed for the current disconnect between less dovish monetary policy and relatively unchanged financial conditions — some that are reinforcing and others less so.
One set of reasons relates to the willingness and ability of central banks to validate expectations for monetary policy tightening. Informed by the experience of several years, some feel that central banks will not have the stomach to go through with removing stimulus. Others believe they will be quickly forced into a U-turn as the economy, long conditioned by ultra-loose policies, struggles with a withdrawal of liquidity — and particularly so given that the Fed overly delayed its policy adjustments and now has to bunch together three contractionary measures.
A second set is based on the view that, given the relative magnitudes involved, it is the existing liquidity that matters rather than the reversal in flow. Financial conditions will continue to be governed by the enormous amount of liquidity sloshing around the system rather than the incremental policy changes. It is a view that is reinforced by the fact that, despite the anticipated measures, the 2022 monetary policy stance is likely to remain accommodative overall.
The third set is more behavioral in nature. Given the multiyear conditioning of markets by ultra-dovish central banks, it will take time to persuade investors to fully price the new policy realities. In this thinking — and especially given the deep anchoring provided by the combination of BTD/TINA/FOMO (Buy the Dip because There Is No Alternative to risk assets, especially given the Fear of Missing Out), markets would need unambiguous and overwhelming evidence of a durable change in policy before pricing it fully.
Almost regardless of the reason, the disconnect undermines the likelihood of a timely and orderly adjustment, thereby increasing the risk of a policy mistake and undue damage to livelihoods. To assess this over the next few weeks and months, we would be well advised to:
- Look more to developments in fixed income than in stocks to assess the degree to which financial conditions have started to tighten.
- Focus on changes in yields on shorter-term bonds (up to five years) as reflective of effective policy expectations more than longer-term ones, which are influenced by a much bigger set of factors.
- Recognize that the economic impact will take time and is likely to lag financial market developments.
- Appreciate that the adverse implications for developing countries are more front-loaded, especially when (not if) the flow of capital to them reverses in earnest.
When some talk about the possibility of a new conundrum, it is important to recognize that the longer the disconnect persists, the more it may narrow what is already a small window for an orderly policy, market and economic adjustment.
Because the Fed was late to react to the pronounced change in the macroeconomic paradigm — from deficient aggregate demand to deficient aggregate supply caused by quite persistent supply chain disruptions and labor shortages — the global economy faces a bigger range of potential outcomes in 2022 and beyond. Now it also has to navigate a delayed and uncertain reaction of financial conditions.
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Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."
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