By Mohamed A. El-Erian of Project Syndicate
SEATTLE (Project Syndicate) — After a year that involved one of the biggest U-turns in recent monetary-policy history, central banks are now hoping for peace and quiet in 2020. This is particularly true for the European Central Bank and the U.S. Federal Reserve, the world’s two most powerful monetary institutions.
But the realization of peace and quiet is increasingly out of their direct control; and their hopes would easily be dashed if markets were to succumb to any number of medium-term uncertainties, many of which extend well beyond economics and finance to the realms of geopolitics, institutions, and domestic social and political conditions.
What a difference a year makes
Just over a year ago, the ECB and the Fed were on the path of gradually reducing their massively expanded balance sheets, and the Fed was increasing interest rates from levels first adopted in the midst of the global financial crisis.
Both institutions were attempting to normalize their monetary policies after years of relying on ultra-low or negative interest rates and large-scale asset purchases. The Fed had raised interest rates four times in 2018, signaled further hikes for 2019, and set the unwinding of its balance sheet on “autopilot.” And the ECB had ended its balance-sheet expansion and begun to steer away from further stimulus.
A year later, all of these measures have been reversed.
Rather than hiking rates further, the Fed cut them three times in 2019. Instead of reducing its balance sheet, the Fed expanded it by a greater magnitude during the last four months of the year than at any comparable period since the crisis. And far from signaling an eventual normalization of its rate structure, the Fed moved forcefully into a “lower-for-longer” paradigm.
The ECB, too, pushed its interest-rate structure further into negative territory and restarted its asset-purchase program. As a result, the Fed and the ECB cleared a path for many interest-rate cuts around the world, producing some of the most accommodative global monetary conditions on record.
This dramatic policy turnaround was particularly curious in two ways.
First, it materialized despite growing discomfort — both within and outside central banks — about the collateral damage and unintended consequences of prolonged reliance on ultra-loose monetary policy. If anything, this discomfort had grown throughout the year, owing to the negative impact of ultra-low and negative rates on economic dynamism and financial stability.
Second, the dramatic reversal was not a response to a collapse in global growth, let alone a recession. By most estimates, growth in 2019 was around 3% — compared to 3.6% the previous year — and many observers are expecting a quick rebound in 2020.
Rather than acting on clear economic signals, the major central banks once again succumbed to pressure from financial markets.
Examples include the fourth quarter of 2018, when the Fed reacted to a sharp stock-market selloff /zigman2/quotes/210599714/realtime SPX +0.34% that seemed to threaten the functioning of some markets around the world. Another occurred in September 2019, when the Fed responded to a sudden, unanticipated disruption in the wholesale funding (repo) market — a sophisticated and highly specialized market segment that involves close interaction between the Fed and the banking system.
This is not to suggest that central banks’ objectives weren’t at risk on each occasion.