Commentary from Scotiabank's Guy Haselmann
How Did the Story of Goldilocks and the Three Bears End? – She Ran Away
- Janet Yellen is inheriting a policy framework precisely at the time when the FOMC is in the midst of pivoting policy. History suggests that financial crises usually arise when central banks pull back from periods of over-accommodation or when Atlas-complex policy-making tries to do too much.
- The FOMC has a tricky balance as accommodation needs to be removed quickly enough so that investors do not become too worried about asset bubbles or inflation, but not too quickly so that investors jump well-ahead of the Fed. (Not too hot, but not too cold – just right)
- The FOMC’s hope is that its decision to initiate ‘the taper’ has been timed appropriately-enough to allow artificially-boosted risk asset valuations to be validated by the fundamentals, thus navigating a soft landing. The intent is to anchor the front end of the yield curve, so that markets can adjust to the new policy direction in an orderly manner and with muted volatility.
- After ‘pedal to the metal’ policy, Bernanke has indicated that the new plan is to ease the foot off the accelerator at a steady rate of decline. The Fed is swapping asset purchases with forward promises; however the switch may not result in the expected off-set anticipated by officials. Using the QE “dimmer switch” approach - as Rosengren called it - to recalibrate during the unwind process may not be a strong enough tool to prevent the Fed from losing control of the process.
- Unintended consequences may have developed from QE policies that are not fully understood. They may materialize more clearly during the withdrawal process. Any of a number of obstacles could push the Fed ‘off course’ from the smooth landing that its baseline scenario suggests:
- Certainly, expanding the balance sheet by over $3 trillion has had a significant impact on valuations, market functioning, and asset allocation, so those effects could cause some market turbulence as they revert back to normal.
- Emerging markets, which benefited heavily in the early years of QE, have recently shown some disruptions, such as, slowing economic growth, weakening currencies, and capital outflows.
- Political and social concerns about income and wealth inequalities have grown due to the use of asset prices as a policy tool.
- Structural unemployment from long-term joblessness and technological advancement cannot be addressed through easy money.
- Politics is still polarizing, which in turn creates on-going economic headwinds.
- Vast uncertainties remain; yet, financial markets appear priced closer to perfection with expectations that sustainable private sector-led growth will propel equity markets ever-higher.
- “Help” - Goldilocks