Mohamed El-Erian

Life is Getting Harder for Central Banks

For reasons largely outside its control, the Federal Reserve is now being widely blamed for fueling financial market instability and risking derailment of the U.S. economy. This is quite a contrast from just a few month ago, when it was still being feted by many for its role as an active and effective repressor of financial market volatility. It is probably only a matter of time until the European Central Bank finds itself in a similar, perhaps tougher position. The reality is both central banks have entered a new, more uncertain phase that is likely to last for some time, requiring more skillful policy navigation and communication, and some operational changes.

Coming out of the 2008 global financial crisis, central banks went out of their way to boost asset prices as a means of supporting the economy. They suppressed volatility by driving down interest rates; buying huge amounts of debt securities and housing them securely on their balance sheets; and, when a bout of volatility occurred, being quick to reassure markets of their broad and consistent support.

This unprecedented phase of central banking had its natural limits.

As detailed in my 2016 book, the benefits of buying time for the economy to heal came with costs and unintended consequences. Accordingly, when the conditions to normalize policy arose, the Fed pivoted by stopping its asset-purchase program, hiking interest rates nine times and slowly reducing its balance sheet. The ECB followed with a considerable lag. After tapering its asset-purchase program during the past few months, it will halt it at the end of this year and may start raising rates during the summer.

But what started out as a relatively smooth and orderly process has become more problematic -- especially for the Fed, which is being accused of fueling financial volatility and risking the country’s economic well-being.

Stock markets are experiencing wild intraday swings, while falling prices have delivered one of the worse Decembers ever for equities. With that, the measure of household consumer sentiment reported last week came in below consensus forecasts, at the same time that consumer confidence expectations also tumbled.

Yet much of the volatility of recent weeks is due to factors outside the Fed’s control. They include:

- A slower global expansion as both Europe and China struggle to implement of pro-growth policies;

- Other economic concerns, from the partial shutdown of the federal government to trade policy as markets wait to see which concessions China will offer the U.S. to end the trade war between the two countries;

- Asset prices that, for years, were decoupled from fundamentals amid ample and predictable liquidity; and

- The proliferation of passive investing, computer trading and exchange-traded funds, including some that promised liquidity in inherently less liquid asset classes, potentially amplifying the risk of contagion both on the way up and on the way down.

It is only a matter of time until the spot light also shines on the ECB. Because its normalization process is now focused on balance-sheet policy rather than the more visible interest-rate moves, it hasn’t yet attracted the same attention as the Fed. Yet this process faces many more questions on account of the slow growth in the euro zone, some weaknesses in the region's banking system, pockets of excessive indebtedness and political gridlock that limits needed structural and fiscal reforms.

Against that backdrop, the risk has risen that volatility could undermine the global economy, and that some investors may lose confidence in the orderly functioning of financial markets. Naturally, this is obscuring the benefits of a long-due transition to a less distorted financial regime that, otherwise, would have threatened much larger economic damage down the road.

There is no easy way out of this situation. Indeed, the spotlight will shine even more brightly on the Fed next year. This will become most apparent at the news conferences, now to be held after each Federal Open Market Committee meeting, where Chairman Jerome Powell is asked to opine on inherently tricky and uncertain policy decisions, options and outlooks.

Whichever way you look at it, central banks will be exposed to more criticism from politicians, market participants and analysts. Having said that, there are a few things they could do. For example, in the case of the Fed, consideration could be given to the following steps, including in the context of the review of communications practices that Powell has already launched: Conveying more consistently and credibly that policy makers are sensitive to the risk of spillbacks from a weakening global economy and market disruptions; signaling the possibility that the automatic pilot governing its balance-sheet reduction is subject to review; and phasing out the blue dot plot that shows policy makers' individual expectations for future rate increase in favor of communications that portray the range of possible outcomes. This might be more along the lines of what the Bank of England does with its quarterly inflation report.

These steps will not take the Fed out of the firing line. Yet they can play a role in lowering the risks of a policy mistake or market accident.