Inflation at a level not seen for a long time makes it possible: the topic monetary policy tightening has moved onto the agenda again. In the US, the Fed has begun reducing securities purchases – so-called “tapering”. And in some emerging markets, as well as in Norway, New Zealand and South Korea, key interest rates have already been raised. The European Central Bank (ECB), on the other hand, is being coy and hesitant. However, the markets do not really believe that the ECB will stand still for a longer period of time.
Will monetary policy gradually become more “normal” again – in the sense of balanced, with interest rate reactions upwards as well as downwards? Or is it more likely that, after tentative attempts at tightening, the first signs of displeasure from shareholders and stakeholders will lead central bank to reverse the monetary-policy course again?
Unfortunately, the latter is to be feared. The reason is the foreseeable costs and braking effects of higher interest rates. On the one hand, monetary tightening and the associated rise in real interest rates entail the risk of an unintentionally severe economic slowdown. On the other hand, this could have a massive impact on the financial markets: There, the long-standing central bank actions have seriously interfered with pricing mechanisms, overriding them in large parts of the bond market and leading to misallocations and overheating tendencies via the portfolio channel. Withdrawal of the drug “cheap money” therefore threatens turbulence. And last but not least: Global debt, which is getting out of hand, would no longer be financeable “for free”; fiscal woes would dominate.
Not so long ago, central bankers would probably have said “so what?” in view of such risks and acted within their focused mandate to maintain price stability. In the meantime, however, the regime has changed. Sustained action is therefore less likely: monetary watchdogs are unlikely to be prepared to face these consequences.
In an exchange of traditional behavioural patterns, the principle of reverse authoritativeness has now become established for the relationship between monetary policy and financial markets. Central banks are increasingly responding to the signals and needs of the capital markets rather than the other way round. The result is an asymmetrical policy: rapid and significant interest rate cuts, but only very hesitant and small interest rate increases, if at all.
How could it have come to this? The seeds for this development were sown with the worldwide deregulation and liberalisation of financial markets in the 1980s and 1990s. There is scientific evidence that this led to the birth and subsequent decoupling of the financial-market cycle from the business cycle. What is more, it is now clear that the former even dominates and lives about twice as long as the latter. Moreover, history teaches us that deep recessions and sustained deflationary scenarios result – if at all – from the bursting of asset bubbles.
If one wants to pinpoint the starting point of the change of heart to a specific date, the Fed’s reaction to the 1987 stock market crash can be considered a fall from grace. That was the first time that the central bank explicitly responded to falling stock prices. Wall Street later created a new term for this: the “Greenspan Put”. However, financial dominance really took off after the great financial crisis of 2008. Since then, the reaction pattern has been perfected. In this context, the ECB adopted the PFFC regime: “preserve favourable financing conditions”. And since the middle of this year the euro central bank has been regularly publishing a Survey of Monetary Analysts (SMA), in which it asks market participants for detailed information on when they expect the ECB to take which action. This feeds the suspicion of who is a cook and who is a waiter these days!
Against this backdrop and with a view to the question posed at the outset as to whether monetary policy will return to “normal”, the central banks thus find themselves in a dilemma. At present, no real departure from the aggressively relaxed approach that has been in place for years is to be expected. And this despite the formation of bubbles and sentiment-related exaggerations in sub-markets. Just think of the almost 70% weighting of US equities in the global index, real estate markets, cryptos, SPACs (Special Purpose Acquisition Companies) or meme phenomena.
For investors, this has three implications: First, more than ever, diversification is of utmost importance for any forward-looking investment strategy. Secondly, the same applies to agile active portfolio management, which includes a dynamic risk strategy. Both requirements may seem old-fashioned to investors, but they remain imperative. Thirdly and finally, income strategies are advisable in view of the low interest-rate environment that is likely to persist for a long time to come. In equities, these can be implemented by focusing on dividends, for example.
Ultimately, this triad is certainly primarily a reminder of traditional, conservative investment principles. However, monetary policy is currently upside down – keywords: financial dominance and the fight for rather than against inflation. Not to mention the Modern Monetary Theory (MMT). Its ultimate consequence would be the loss of central banks’ institutional independence, which would be deeply regrettable. In view of this threatening backdrop, the aforementioned reconsideration seems very suitable for at least putting one’s own capital investment on a solid footing.
Column by Ingo Mainert, CIO Multi Asset Europe at Allianz Global Investors
For Funds Society, Madrid