The world’s central bankers have a message for investors stung by the ongoing roller-coaster ride in financial markets: Don’t count on us to bail you out with easier credit.
Federal Reserve (Fed) chairman Ben S. Bernanke, European Central Bank (ECB) council member Axel Weber and Bank of Japan (BoJ) policy maker Atsushi Mizuno all play down the significance of the global shakeout on their economies and are signalling they still see inflation as a greater risk.
“The global economy continues to perform very well, with solid growth and relatively low inflation,” John Lipsky, the International Monetary Fund’s second-ranking official, said in a 2 March interview. Among global central banks, “policies seem on track,” he said.
That would keep the ECB and BoJ on a course to continue tightening credit, while the Fed holds rates steady throughout 2007. Such an outcome would disappoint investors who have bet the turmoil will prompt policy shifts by the central banks. Dealers marked up the chances of a Fed interest-rate cut by mid-year and lowered the odds on future increases by the ECB and BoJ after a selloff in China sparked the global rout.
The Dow Jones Industrial Average on 27 February dropped as much at 546 points, the most since just after the 11 September 2001 terrorist attacks. The Morgan Stanley Capital International World Index lost more than 4% in the week, its biggest slump in eight months.
Some economists say central bankers, in advocating a steady-as-she-goes monetary policy, are being too sanguine about the dangers confronting the global economy. With new-home sales and durable-goods orders in the US plunging in January, the risk of a slowdown in the world’s largest economy is rising.“The significance of the market meltdown for the US is that we are going to get a recession,” says Nouriel Roubini, chairman of Roubini Global Economics and professor of economics at New York University said, “The Fed will have to cut rates sooner or later, but that won’t prevent it.”
Futures traders put the odds of a Fed rate reduction by July at 70% on 2 March, up from 14% two weeks earlier. In Europe, some traders last week abandoned all bets that the central bank would raise rates this year. Central bankers are confident that the global economy is strong enough to withstand the financial fallout from last week’s market turmoil.
“We do not see a recession coming,” Federal Reserve Bank of St Louis President William Poole said in a 2 March interview in Santiago, Chile. “At this point it seems to me there is no pressing need for any immediate action.” In the euro region, where ECB is almost certain to raise its benchmark rate a quarter-point to 3.75% on 8 March, Weber is pushing the case for still further increases to curb inflation.
“A more significant normalization of monetary policy is needed,” Weber, who heads Germany’s Bundesbank, said in a 28 February interview.
In Japan, BoJ board member Mizuno said the same day that the market’s drop wouldn’t deter the bank from its policy of “gradual” rate increases to prevent the world’s second-largest economy from overheating. “We aim to gradually adjust interest-rate levels according to changes in the economy and prices,” he said.
Eisuke Sakakibara, former currency-policy chief at Japan’s ministry of finance, says it’s possible BoJ will raise its benchmark rate again as early as May after doubling it to 0.5% on 21 February.
The central banks would surely rush to flood the global economy with money if a market freefall threatened the stability of the financial system. That’s what the Fed did following the US stock market crash in October 1987, and again after the 2001 terrorist attacks on New York and Washington. There’s no sign of such systemic breakdown this time.
The Fed is “closely monitoring the markets,” Bernanke told the House Budget Committee. “They seem to be working well, normally.”
Rather than seeing the trading turbulence as a harbinger of tougher times for the global economy, central bankers are more likely to view the volatility as a welcome wake-up call for investors who had become too complacent about risks.
“It was an accident waiting to happen,” says Willem Buiter, professor at the London School of Economics and a former Bank of England policy maker. “They will monitor it very closely but I don’t think that anyone at the central banks will be tossing and turning in their sleep.”
Policy makers have been cautioning investors for months that they were taking too many risks. Central bankers worried that the fastest global expansion in a generation had lulled investors into a false sense of complacency, encouraging them to pour money into emerging markets and sub-prime mortgages in the US without understanding the risks.
ECB president Jean-Claude Trichet said on 27 January that markets “have to be prepared for a re-appreciation of risk,” which he described as “likely.”
Investors nursing the past week’s losses are still sitting on gains following a four-year rally in equities. The MSCI World Index, which has doubled since March 2003, is still 12% above its year-ago level.
Some economists worry global borrowing costs are still too low given the strength of growth, and may encourage traders to take further risks once markets settle down. In Japan, low interest rates have prompted investors to borrow the yen and invest in high-yielding assets elsewhere, a practice referred to as the carry trade. While the selloff led some investors to abandon the tactic, sending the yen to its biggest weekly gain against the dollar in 14 months, the BOJ’s main rate of 0.5% remains 475 basis points below the Fed’s.
“Markets will continue to enjoy relatively favourable monetary policy conditions,” says Thomas Mayer, chief European economist at Deutsche Bank AG in London.
Stock markets have already recovered from one slump in the past year, a drop in May and June prompted by concern the Fed would raise rates more than previously forecast. The MSCI World Index lost 9% during that period and recouped those losses by October. With rates sustaining the world’s strongest period of expansion in three decades, bankers say investors should learn to look after themselves.
“If you misprice risk, don’t come looking to us for liquidity assistance,” says Weber. “The longer this goes on and the more risky positions are built up over time, the more luck you need.”