TSLombard with the note:
With vaccines curbing the potency of COVID-19, policymakers can begin to unwind their fiscal and monetary support programmes–starting with QE. Central banks’ asset purchases have had only modest effects on GDP and inflation, but they are important for financial markets. While the authorities will avoid a new”taper tantrum”, investors should expect more volatile asset prices.
There are 1833 words left in this subscriber-only article.
Start your free 14-day trial today!
Global policymakers are looking to unwind the massive support programmes they introduced at the start of the pandemic. Fiscal policy–crucial for preventing mass unemployment and a wave of bankruptcies–will tighten automatically as economies return to normal. But central banks will have to plan their own exit more deliberately, starting with the decision about how to end QE.
Central banks tend to exaggerate the effectiveness of QE. Beyond crisis episodes, QE has only a modest impact on GDP and inflation. Unwinding this policy is unlikely to damage the real economy, especially if the fiscal authorities become more “activist”. But QE matters for financial markets, where the central-bank“backstop” alters the entire distribution of asset-price returns.
Exiting QE can be tricky, especially if investors bring forward their expectations for rate “lift-off”.The authorities will proceed cautiously. Central banks will also be hoping that governments adopt a more relaxed attitude to fiscal deficits and public debt in the 2020s, as this would allow them to reserve QE for what it is good at–supporting financial markets during times of crisis.
When discussing “risks” to markets, there is always a temptation to focus on those threats that are readily identifiable rather than those that are harder to spot or less tractable. For months, investors’ main focus has been on the danger from rising inflation, though we have struggled to find anyone who doesn’t not believe most of the current leap in the CPI is “transitory”. Now investors’ attention is shifting to the second-most identifiable risk in the market: the danger that stems from policymakers trying to unwind the extreme support programmes they introduced at the start of the pandemic. This is also part of the “Peak Everything” narrative–the idea that market conditions will inevitably become more challenging into 2022. Not only have we passed the easiest phase of the COVID economic recovery (reopening); we are also facing the“daunting prospect”(to quote the BIS) of both governments and their central banks trying to“normalize” policy after the biggest macro economic intervention since World War II. The good news is that the fiscal part of this adjustment–which was the more important intervention for the macro economy–will happen automatically. As“locked-down”sectors recoverand people return to work, the need for government transfers will naturally diminish. Central banks, however, will need to plot a more deliberate exit from their recent interventions. The course they choose could have profound implications for how financial markets perform in 2022 and beyond.
The withdrawal of monetary stimulus will start with central banks trying to reduce their massive QE programmes (i.e.,tapering). Despite the widespread use of this policy over the past decade, the impact of QE remains highly controversial. A new NBER study suggests central banks have been wildly exaggerating the macroeconomic benefits of these interventions, a case of officials“marking their own homework” (and then getting promoted for their efforts). Yet there is no doubt QE has been important for financial markets, especially during episodes of extreme turbulence. At the start of the pandemic, massive central-bank asset purchases stabilized asset prices and prevented a disastrous feedback loop between financial markets and the real economy, which could have produced a crisis similar to that of 2008. In fact, there is also evidence that QE influences financial markets beyond severe crisis episodes (which is not something that can be said about its impact on the real economy). Not only does the QE backstop reduce the “left-hand side” of the distribution for equity returns, by making extreme declines in prices less frequent; it also shifts the “right-hand side” of the distribution, raising the potential gains to investors (while increasing average daily returns). We suspect this is due toQE’s effect on psychology and risk premia rather than “liquidity” or bond-market “distortions”.
Because of what happened when the Federal Reserve tapered its asset purchases in 2013, central banks are now fully aware of the risks associated with exiting QE. Their main worry is that winding down their asset purchases will undermine the credibility of their interest-rate guidance, prompting markets to anticipate an earlier“lift-off”. We suspect the authorities will manage this threat by downplaying the prospect of early rate hikes and trying to shift investors’ attention to lagging indicators of the COVID economic recovery, especially employment and the risk of “scarring” in labour markets. This means, even if the recent decline in bond yields is likely to reverse, there will be no fully-fledged (2013-style) taper tantrum. It also means a more volatile environment for risk assets. Some pundits, meanwhile, are worried about the fiscal risks associated with QE. Central banks’ asset purchases have reduced the maturity of government liabilities, and this could become a problem when interest rates rise. Yet it would be a mistake to think “fiscal dominance” is the issue that will prevent central banks from exiting QE. In fact,only a more relaxed attitude to deficits and public debt will allow those institutions to escape from the“QE trap”–where they have been stuck for the past decade–relegating this policy to what it is good at (a market backstop) rather than a desperately ineffective macrostimulant of first resort.
Amid all the focus on inflation in recent months, investors are now switching their attention to the second-most identifiable threat to global markets–the impact of the authorities withdrawing the policy support they introduced at the start of the pandemic. From a macroeconomic perspective, it is fiscal policy that has done most of the heavy lifting during this crisis. Without the biggest fiscal expansion since World War II, most economies would have suffered mass corporate bankruptcies and unemployment at depression levels. As the world reopens from the crisis, the need for fiscal support will fade. This adjustment should be mostly automatic, though there is a danger of policy mistakes–for example, if some governments try to tighten their budgetary positions prematurely. Most investors, however, are more interested in what is going to happen on the monetary side, starting with central banks attempting to wind down their massive QE programmes. While there is no real evidence that–contrary to what the authorities claim–QE boosts GDP and inflation in a meaningful way, the policy does have a powerful impact on the distribution of asset-price returns. This is not about “liquidity” in the popular sense of the term but rather about central banks’ willingness to backstop financial markets in times of stress. QE also affects investor psychology, even without keeping bond yields “artificially low”. How risky is the QE “Pandexit” for global markets? Central banks will proceed cautiously, which makes a full taper tantrum extremely unlikely. That said, the recent decline in US yields is unlikely to persist and investors should expect greater volatility for global markets in the post-QE world.
Meh, I very much prefer the Viktor Schvets notion of an inflation and stimulus pendulum against a backdrop of persistent and structural disinflation meaning that exiting and entering bonds and equities is simply taking the opposite trade to policymakers over and again.