The Lords of Money Pose Massive Threats to Markets

When central banks unexpectedly go into full reverse, watch out


By James Mackintosh, The Wall Street Journal (WSJ)

June 19, 2022


Think the Fed’s job is hard? At least the U.S. Federal Reserve can concentrate on fighting inflation. In Japan and Europe, the central banks are battling the markets, not merely price rises. That’s leading to some very strange, even contradictory, policies.


The troubles of the three central banks mean investors should prepare for the sort of low-probability, high-threat risks that lead to extreme shifts in prices. When central banks unexpectedly go into full reverse, watch out. Let’s go through the risks.


The Fed failed to stem inflation because it spent too long looking to the past, as part of its policy of being “data driven,” and so kept rates too low for too long. By sticking to the data-driven mantra, it risks repeating the mistake in the opposite direction, raising the chance that it causes the next recession and has to do a 180. Since the markets have barely begun to price in a recession and so a fall in earnings, that would hurt.


On Wednesday, Fed Chairman Jerome Powell went even further, saying he wouldn’t “declare victory” over inflation until inflation has been falling for months. Since inflation typically peaks right at the start of a recession or after it has begun, this makes it hard for the Fed to stop tightening.


Mr. Powell talked about finding out empirically what level of interest rates slows the economy enough. My read of that is that the Fed has committed to keep hiking until something breaks.


The European Central Bank has a familiar problem: politics. On Wednesday the ECB held an emergency meeting to address the problem of Italy, and to a lesser extent Greece. The ECB wants to damp down the rising heat in Italian bonds, where the 10-year yield rose to 2.48 percentage points above Germany’s before falling after the ECB action.


Unlike a decade ago, when the then-ECB head and now Italian Prime Minister Mario Draghi pledged to do “whatever it takes,” the central bank’s action has come before a fire breaks out, which is commendable. But the interim measure of redirecting some of the maturing bonds bought as pandemic stimulus into troubled eurozone countries is relatively small.


The ECB promised to accelerate work on a new “anti-fragmentation instrument” as a long-term solution, but here’s where it runs into politics. The rich north has always demanded conditions in return for shoveling money into troubled countries, to ensure they don’t use lower bond yields as an excuse for yet more unsustainable borrowing. But until the flames are engulfing the economy, troubled countries don’t want the embarrassment—and political catastrophe—of accepting oversight from the International Monetary Fund or the rest of Europe...


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