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Fed and Markets Resume Their Unhealthy Co-Dependency

Monetary policy is once again swamping factors like economic growth and geopolitics for traders, threatening financial stability.

21 December 2023 at 19:30 GMT+8

Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”

Christmas came early for markets this year. Photographer: Angela Weiss/AFP via Getty Images

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The Federal Reserve was supposed to leave center stage by the end of the year and let other factors play the leading role in determining asset prices in the advanced world and beyond. Instead, it has written itself an encore act that’s full of confusion.

Monetary policy was often the only game in town when it came to determining market outcomes for much of the last 15 years. Central bank policy measures and statements (also known as forward policy guidance) as well as market expectations of what they would do and say had a disproportionate influence on asset prices; at times, meaningfully decoupling valuations from economic and geopolitical realities.

For more than a decade starting from the 2008 global financial crisis, central bankers flooded the system with liquidity and floored interest rates. They pivoted sharply in the last two years to a highly concentrated cycle of rate increases, necessitated by the mistake of initially characterizing inflation as transitory, before moving to signal that rates will stay high for long.

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The near exclusive focus on monetary policy was supposed to fade as we attained “peak rates” and retreated only modestly from there over time, accompanied by an auto-pilot shrinkage of bloated central bank balance sheets via quantitative tightening. Central banks’ deterministic influence on asset prices was to give way to other factors, particularly the outlook for economic growth, the smoothness of the last mile of the inflation fight, and the availability of funds to readily absorb the step-up in debt issuance due to large deficits and higher borrowing costs.

This is not what is happening. Rather than slowly moving to the wings, the Fed in particular reinforced its lead role last week by spurring massive price moves in virtually every asset class. Chair Jerome Powell’s words about the potential for interest rate cuts have reverberated around the world, influencing expectations of what other systemically important central banks will do.