Central banks in general and the Fed in particular have faced a tough question over the past two years or so: Are they out of bullets?
But recent developments indicate an even thornier issue: What if aggressive monetary actions not only have run their course, but are actually causing damage?
Central banks in the U.S., Europe and much of Asia have been cranking out the easing programs since the Great Recession spread around much of the world.
The results have been mixed: In staving off a complete global collapse, the banks have managed to push up asset prices but their respective domains remain mired in weak economic growth and, around Europe, the prospect of deflation rather than the inflation the policies sought to trigger.
With the Fed trying to normalize policy while others, most recently the European Central Bank, still in full easing mode, questions are arising as to whether the central banks not only have done all they can and should, but also risk causing more troubles by continuing down the current path.
“The empirical record indicates multiple episodes of CB easing actions that resulted in large and opposite reactions to those intended,” Binky Chadha, chief global strategist at Deutsche Bank, and others said in a report for clients. “Those that succeeded either coincided with positive fundamental developments or were part of a package that led to expectations of such.”
In the case of the ECB and Bank of Japan in particular, attempts to replicate the successes, such as they are, of the U.S. Fed’s quantitative easing have yielded little fruit.
European equities have mostly underperformed during the ECB’s easing efforts, while Japan saw rangebound trades both for stocks and the yen. The bear market in oil began right around the time the ECB went to negative interest rates. Fund inflows to high-yield bonds also dried up around the same time, Chadha noted.
“The Fed’s QEs and their believed success has been the driver of the ECB and BOJ’s recent initiatives,” he wrote. “But as we have noted previously, the various Fed initiatives all coincided with low points in the data surprise cycle which would have reversed anyway, without any discernible impact on the trajectory of the economic recovery. They also resulted in a large rotation from equities into bonds.”
In other words, the economy was at a low point and bound to rebound anyway. At the same time, while the market jumped, much of investor fund flows actually moved to fixed income instead of stocks.
The Deutsche team outlined what it termed “unintended impacts and risks”:
“Uncoordinated aggressive easing, such as the ECB’s move in mid 2014 was responsible for the sharp move up in the dollar and with the rest of the world’s loss in dollar purchasing power, the collapse in oil prices,” the report said. “The impacts on the dollar and oil explain why inflation expectations in Europe moved opposite to what the ECB intended. The speed of the dollar move also shaved off enough from U.S. growth and earnings to have kept U.S. equities, the barometer of global risk appetite, range bound since mid-2014.”
To be sure, central bankers insist they still have tools to affect growth in a positive way. And after Wall Street’s seesaw day on Thursday following ECB President Mario Draghi‘s announcement of another round of easing, markets rallied strongly in an apparent vote of confidence for more easing.
But Chadha and his team aren’t the only ones to note that the end of the road is approaching for central banks.
Mohamed El-Erian, the chief economic adviser at Allianz, in his new book “The Only Game in Town,” noted the dilemma as well.
“We are rapidly nearing an inflection point where central banks will find their policy approach increasingly and consequentially ineffective,” he wrote. “As financial volatility increases, a limit will be reached: It will no longer be possible to artificially repress financial risk while also decoupling it from the anchor provided by fundamentals. At some point, and I believe that point is approaching fast.”