LONDON – Alan Greenspan’s conundrum is back, and central bankers’ new-found love of treating markets with kid gloves is playing a large part.
While the U.S. Federal Reserve is expected to raise interest rates for the third time this year, and officials expect another three hikes in 2018, benchmark U.S. bond yields have remained stubbornly low through 2017 and the gap between short and long-term rates has flattened.
At the same time, stocks have continued on an upward ascent, with the S&P 500 hitting record after record and the Dow Jones Industrial Average breaking through 24,000.
The Bank for International Settlements highlighted the issue in its latest Quarterly Review, where it said investors have “shrugged off” the Fed’s moves.
“Financial conditions have conspicuously eased in U.S. markets over the last 12 months, despite the Federal Reserve’s gradual removal of monetary accommodation.”
The situation isn’t unprecedented. The BIS noted it has echoes of what former Fed Chairman Greenspan describe as a “conundrum” in 2005. He found it puzzling that long-term bond yields were falling even after a series of Fed rate hikes.
Both episodes differ from previous cycles, such as 1994, when Fed actions “triggered sharply higher long-term yields, moderate stock market losses, wider credit spreads.”
While the persistence of low inflation globally since the financial crisis may be part of the explanation, the BIS said central bankers themselves are a significant factor.
“The difference between the last two episodes and that of 1994 reflects shifts towards greater gradualism and predictability in the Fed’s tightening strategies. The Fed’s moves in 1994 were steep and less thoroughly communicated to markets. By contrast, gradualism and predictability have characterized the current tightening cycle, with respect to both the policy rate and balance sheet adjustment.”
In other words, monetary officials are mollycoddling markets, in the U.S. and elsewhere. The Bank of England’s rate hike in November — the first in a decade — was accompanied by a pledge that tightening will be “limited and gradual.” It looks likely to raise interest rates only about once a year as the U.K. negotiates its exit from the European Union. The European Central Bank has slowed its bond-buying program but won’t end it until at least September 2018. The Bank of Japan is showing no sign of any major shift in its easing policy.
The BIS has long pushed for tighter policy globally and Jaime Caruana, who retired last week as head of the Basel-based institution, warned that central banks shouldn’t underestimate the dangers of moving too slowly.
“Postponing normalization too much also has risks,” Caruana said in an interview. “Why? Because there is more risk-taking and it’s difficult to know where the risk-taking will go.”
While gradualism is one part of the equation, communication is another, according to the BIS, which said policy decisions in the current cycle were “well anticipated.”
“In the absence of imminent inflationary pressures, such as those prevailing in 1994, in the two more recent episodes the Fed’s gradual approach may have supported investors’ beliefs that the central bank would not risk impairing growth and damaging valuations.”
Central bankers are still worried about market ructions that could undermine the current economic upturn — and they really want to get inflation up even more. The upshot is that they’re hand-holding investors all the way to their policy decisions.