Column: ECB, Fed pile risk upon risk – James Saft

November 12, 2013

By James Saft

(Reuters) – With the European Central Bank and U.S. Federal Reserve pulling the same way, global interest rates will be lower for longer, feeding an ongoing rally in risky assets.

But since monetary policy has a bigger impact on financial markets than the real economy – arguably, anyway – the bigger the paper gains get, the more acute the risks become.

The ECB surprised virtually everyone last week when it cut its key lending rate to 0.25 percent, reacting to an uncomfortable slide in inflation and an equally vexing rise in the value of the euro.

Following on the Fed’s decision not to slow bond purchases in September, this marks the second time in less than two months that a major central bank has shocked investors with dovish policy.

And to judge from the noises coming out of the Fed, we are running out of excuses for being surprised.

“Although the series of upside surprises in economic data releases in the U.S. recently has increased the risk of an earlier taper, we believe forward guidance could be used by the Fed to signal that policy will remain ultra-loose for considerably longer than currently indicated,” Societe Generale economist Klaus Baader wrote in a note to clients on Monday.

The taper, the prospect of which was taken by investors as a tightening of conditions over the summer, seems unlikely at the Fed’s next meeting in December. Coming to the end of his tour of duty, Fed Chairman Ben Bernanke would probably prefer to leave the opening gambit to his successor, Janet Yellen, delaying any move at least until March.

An academic paper released last week by key Fed economists may provide a clue as to how, and why, the Fed may decide to try to persuade the market that it intends to keep its foot on the gas for longer (here). Called forward guidance – essentially central banker-speak for promising to follow some course of action in the future – the tactic in this case probably involves pledging to keep rates pinned at low levels until unemployment gets to just 5.5 percent, a full point lower than current guidance and almost two points below the current U.S. jobless rate.

In other words, if we get a taper, it may come with more aggressive forward guidance as a sweetener.


Clearly, both the ECB and the Fed have plenty of troubles to manage. Inflation is well below target in both economic areas, and there are indications that it is in a multi-year downtrend. Unemployment is also an issue, with mass youth unemployment in parts of the euro zone threatening to create a lost generation in the labor force.

Similar forces are at work (or perhaps not) in the United States, as the following comments from Bernanke on Friday underscore:

“There is an awful lot of slack in the labor market – a lot of young people living with their parents and the like – and that is a very important imperative.”

The cost of addressing these issues with monetary policy is a potentially dangerous distortion of risk-taking in financial markets. Just look at the mania in stock markets for riskier investments – from Twitter’s hugely successful initial public offering to the rollicking gains in highly speculative 3-D printer stocks. While anyone who tells you this is definitely a bubble is at best over-confident, you should invite anyone who tells you it definitely isn’t to play poker.

There are other types of risks that build as monetary policy is kept so loose for so long. One is that governments are lulled into a false sense of security, allowing them to put off needed reforms because the so-called bond market vigilantes have been sedated.

A good example of this is in the United States, with the interplay between the Fed and the warring political parties. After having cited the government shutdown as a reason to not taper, politicians might be excused for believing they have a license to grandstand and delay.

The same is definitely true for emerging markets, which may be frittering away the short-term reprieve from tighter conditions they were given when the Fed held off on tapering.

“Emerging market countries have done virtually nothing since then to put themselves in a better position when a taper comes, and if anything more speculative capital has gone into these markets, making these currencies even more vulnerable to a sharp selloff,” hedge fund manager Stephen Jen of SLJ Macro Partners told clients in a note.

Expect, in other words, a bigger rally in any number of risk assets, followed by a bigger and perhaps more violent selloff.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see