When they write the final history of central banks and the global financial crisis, the six weeks from January 29 to March 16, 2016 will be a prominent late chapter.
We went from the Bank of Japan’s (BoJ) surprise adoption of a negative interest rate to the Federal Reserve finally giving ground to market bearishness, with yet another game-changing intervention from the European Central Bank’s (ECB) “Super” Mario Draghi in between. Not coincidentally, the S&P 500 Index rallied 11% from its lows during the same period. Central banks have been looking into the abyss of spiraling negative rates and all-out currency war over recent months—and the last two weeks saw them pull back from the edge.
My colleagues and I have discussed how corrosive negative rates could be for banks and, potentially, for the financial system at large. On top of this, benefits from resulting currency weakness were always likely to be outweighed by slow global growth, rising import costs and other countries entering the fray. Markets felt instinctively uncomfortable: The BoJ’s decision sparked a punishing fortnight for risk assets and a backlash from domestic savers and consumers. If ever a monetary easing announcement backfired, this was it.
Discussion spread well beyond Neuberger Berman, in a tone that I would describe as modestly critical.
Central banks themselves have been part of the conversation, sometimes in public (think of the normally dovish New York Fed President Bill Dudley describing talk of negative rates in the U.S. as “extraordinarily premature” on February 12) and sometimes behind the scenes. At the ECB’s policy announcement and press conference on March 10, a new consensus seemed to be revealed.
The irony is that the ECB did cut its deposit rate again, to -0.40%. It took some of the sting out by extending liquidity to banks at the same rate for five years, and also expanded its quantitative easing program and added corporate bonds to the securities it could purchase. Risk markets liked the news and the euro dived. But Draghi’s comments during the press conference were the real story: “We don’t anticipate it will be necessary to reduce rates further,” he said. He acknowledged the danger that would pose to banks and confirmed a shift “from rates instruments to other, nonconventional instruments.” Suddenly the headline wasn’t negative rates anymore, but the “nonconventional” stuff. Markets really liked that—and the euro soared.
When the BoJ held rates steady five days later, despite a gloomy economic assessment, and added measures to shield banks from its negative rate, that fit the new consensus.
And the Federal Reserve last week? In holding rates and revising its rate projections substantially downward, it finally responded to what markets had been asking for (via their pricing of risk assets and Fed Funds futures) after months trying to break free of those expectations.
But it fit the consensus in other ways, too. In 2015, the roadmap for the Fed’s policy trajectory was unclear: a bit about China and global conditions, a bit about U.S. employment and inflation, but not much about how it was all related. Last week, the message was crystal: We can’t consider U.S. prospects without taking account of global conditions. Despite very modest Fed policy moves so far, U.S. financial conditions have tightened significantly. Why? Because of U.S. dollar strength. And why is the dollar so strong? Because slowing growth led to aggressive monetary easing and weaker and weaker currencies in the rest of the world.
With the ECB and the BoJ choosing more direct stimulus over the rates-and-currencies channel, however, many believe the dollar is unlikely to rise much further from here. The resulting loosening of U.S. conditions may give the Fed wiggle room for its two hikes in 2016. This is what the Fed gains from the new consensus. With Thursday’s core inflation print surprising to the upside, is it possible that Fed Fund futures, which responded to the Fed announcement by lowering the implied probability of a hike in June, are now behind the curve?
We’ll see. The past two weeks have seen a major transition in central bank philosophy, and possibly a renewed sense of coordination. So far, markets have been euphoric at this turn away from the abyss and back towards some kind of “normality.” How this normality ultimately plays out remains an open question.