The Force Is Stronger Than Expected

Central Bank Responses Put Market Scepticism to Shame

What a rally we saw in February and March! On March 21, the S&P 500 Index was 12.1% above the low recorded on February 11, all but wiping out the losses incurred in January. What happened?

The key factor was how central banks, in particular, the European Central Bank (ECB) and the Fed, responded to the combination of weak growth and tighter financial conditions. The markets entered February with the mind-set that central banks were powerless and that any actions by them were likely to do more harm than good. Central banks put those beliefs to shame.

All of the G3 central banks were in action during the week of March10-16. First to meet was the ECB, whose decision to cut the deposit rate by 10bps to -0.4% and reduce the refinancing rate (the rate banks pay when they borrow money from the ECB) by 5bps to 0bps surprised the markets on the upside. Its announcement of another round of long-term refinancing operations and, in particular, the extension of the program to include purchases of bonds issued by nonfinancial corporate entities, was even more of a surprise—it was previously assumed that the German contingent of the ECB would not countenance such a move.

The Bank of Japan (BoJ) was second to meet—and amid weakening growth, falling inflation expectations and a strengthening yen, it decided to do nothing. The BoJ’s inaction has its roots in the operational problems in the interbank market following the introduction of negative interest rates and the subsequent public discontent (Japan remains a nation of savers). Governor Kuroda has already made clear that the system of negative deposit rates will be structured to ensure that ordinary depositors will not be “taxed” on their savings. Once he manages to assure depositors that their savings are safe, the coast should be clear for additional easing of the monetary policy.

Last, but not least: the Fed. As expected, it kept interest rates unchanged, but the “dot plot” (the chart showing the rate path that Federal Open Market Committee (FOMC) members expect over the next three years) revealed that the median member on the FOMC expects only two hikes in 2016—down from an expectation of four hikes at last December’s meeting. Who said that the dot plot serves no purpose? The post-meeting statement attributed the revision of the dot plot to the challenging international backdrop. Congratulations, emerging markets! You have finally become large enough to scare the FOMC into abandoning the kind of tightening cycle that has traditionally pushed you into financial disarray.

Despite all their ingenuities, the G3 policy innovations represent only a marginal loosening of the overall monetary policy stance (relative to cutting interest rates by 100–200bps). Does this loosening of the policy stance matter? Yes. Looser global financial conditions slow down capital outflows from emerging markets, and historical evidence suggests that capital outflows are accompanied by tighter local financial conditions. In this respect, the G3 policy loosening is particularly important for emerging markets, and it provides local central banks with additional degrees of freedom that can be employed to implement a more supportive monetary policy stance.

What comes next for G3 monetary policymaking? The policy easing process has farther to run in Japan: inflation and growth are rolling over, the yen is strengthening, and the stock market rally has petered out. The BoJ will therefore likely ease in April. We await the details of the corporate bond purchase scheme from the ECB—expectations are quite high, which provides some scope for downside disappointments (most likely, the ECB will announce a meaningful but somewhat conservative approach while keeping an open mind as to whether the program can be expanded over time). I believe that the Fed will raise interest rates in June and revise the dot plot in a more hawkish direction to reflect nascent inflationary pressures. Fortunately, June is some time away.

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