Beautiful normalisation rather than harsh regime change

As a kid interested in global current affairs, I came across the notion of politicians signalling one way but looking to turn the other. It was a time of frequent political regime changes, some violent and some relatively smooth. In many of the latter, citizens were assured that a certain comforting path would be maintained while leaders attempted to carefully steer towards a new one. It wasn’t that populations would remain ignorant forever. Even the more self-assured political leaders realised that citizens would eventually notice. Rather, the hope was that this would occur after the benefits of change were being felt, thus reducing the anxiety and resistance triggered by unknown. This has come back to me recently as four systemically important central banks — the Bank of England, European Central Bank, Federal Reserve and People’s Bank of China — engage to varying degrees in a delicate move away from the ultra-stimulative approach that they have been pursuing with vigour. Conscious of how this policy has comforted and conditioned financial markets, their communication has been quite careful. The gradual paradigm shift — away from large-scale asset purchases and ultra-low (and, in some cases, negative) policy rates — is, to borrow a concept brought to my attention a few years ago by Andrew Balls, a former Pimco colleague, correlated rather than co-ordinated. Driven by both common and specific reasons, they are meant to be part of a comprehensive policy transition to a path of higher and more inclusive growth, coupled with genuine financial stability. Employment gains and avoiding future financial instability are among the shared motivations. They have been amplified by specific reasons that include: higher inflation in the UK; shortage in the bonds that the ECB purchases; curtailing excessive credit growth and low-productivity investments in China; and the possibility of tax reform and infrastructure programmes in the US. Keenness for the policy transition is coupled with concern that too visible and abrupt a change would result in the opposite of what is intended — that is, cascading financial instability that undermines economic activity. As such, central banks are, and will remain, careful in what and how they communicate to markets. The hope is — to adapt a concept used elsewhere by Ray Dalio, the founder and leader of Bridgewater — for a “beautiful” policy normalisation of rates and balance sheets. Specifically, an endogenous, broad-based and sustained economic recovery that allows central banks to step back from interfering and distorting market signals and behaviours, thereby reducing the risk of damaging financial volatility down the road.
An even more beautiful normalisation would involve politicians seizing the moment to decisively implement supportive policies in the form of: pro-growth structural reforms; more responsive fiscal stances where there is room; targeted debt reduction; and better cross-border regional co-ordination, including completing a stronger economic architecture in the eurozone. Both scenarios would help validate existing stock prices, replacing the liquidity prop with improved fundamentals. The concern, however, is that a weak endogenous economic recovery and/or further political delays in implementing a more comprehensive macroeconomic policy approach would force central banks to abandon their own regime transition. And the fear is that this could come too late, forcing policymakers to scramble to contain spreading financial instability and rendering them more vulnerable to political interference that curtails their operational independence. This mix of such four potential outcomes is why central banks have, and will continue to be, very cautious in how they communicate to markets. They will come across as more conditional than they really are, seeking to retain both actual and perceived policy optionality. Yet markets should already be adjusting better to the consequential probability that the years of massive central bank support for asset prices will increasingly be in the rear-view mirror. As the one central bank resisting the shift, the Bank of Japan is not in a position to provide the same magnitude of financial volatility repression and boost to asset prices. Accordingly, whether investors maintain the same risk exposures is now less about central banks and more a function of politicians in Europe and the US finally stepping up properly to their economic governance responsibilities.