Since the Great Recession, stock-market investors have been coddled by central bankers petrified by the prospect of a repeat of 2008. From the moment they began pumping extraordinary stimulus into the financial system, monetary policy chiefs have vowed to implement an exit strategy that would force investors to sink or swim on their own. But they always backed out in the end.
Until December, that is, when the U.S. Federal Reserve finally raised its benchmark interest rate for the first time in nine years and telegraphed four increases in 2016. But the worst early-January stock market rout on record threatens to upend that plan, and raises questions about the wisdom of hiking in the first place, exacerbating a central banker credibility gap that will do nothing to tame market volatility.
"At a certain point, when you've committed yourself to raising rates in December, you raise rates in December. But whether that was a prudent commitment to make, I think is very much an open question," former U.S. treasury secretary Larry Summers, who bowed out as candidate for Fed chairman in 2013, told Bloomberg Television last week. "I don't think you invest your credibility in the idea that you're going to have a substantial number of rate increases during the year."
There are plenty of reasons – some founded, others not so much – why global stocks have been tanking. Commodity prices have yet to find bottom. China's economy is slowing and its asset bubbles are bursting. A strong U.S. dollar is depressing exports and inflation. Such negatives are obscuring economic positives, such as strong U.S. job growth and record auto sales.
But who thinks stocks would be off to the worst start to the year ever, had central bankers not committed themselves to taking away the punch bowl that was keeping the party rolling? Fed chair Janet Yellen now faces the humbling choice of reversing course or standing firm on a tightening that risks wreaking more market havoc and sapping consumer confidence.
It's an excruciating dilemma. Just last week, newly released transcripts of the 2010 policy meetings showed how painfully the Fed's Open Market Committee grappled with whether to implement an exit strategy from easy monetary policy that all agreed was essential to restore normal risk-reward incentives to financial markets. In the end, the Fed balked.
"Given the tenuous state of business and consumer confidence, I consider it critical at this junction that this committee not be perceived as falling behind the curve, being unwilling to act or being out of touch with the mounting concerns we see in the markets and on Main Street," Ms. Yellen, then head of the San Francisco Fed, said in August, 2010, according to the transcripts.
Within a few months, the Fed had embarked on the second of three rounds of quantitative easing, or large purchases of Treasury bonds, only ending the program barely a year ago.
The Fed is not the only central bank facing a credibility gap. Bank of England governor Mark Carney has been feeling the heat for saying one thing and doing another since he left the Bank of Canada for the more prestigious post across the pond in 2013. British investors have panned his "forward guidance" as useless in forecasting the direction of monetary policy.
After promising not to raise interest rates until the unemployment rate fell below 7 per cent, Mr. Carney stood pat as the rate plummeted far below that threshold. In August, he said the British economy's "sustained momentum" and "underlying inflationary pressures" would put the bank's decision about when to "normalize" monetary policy "into sharper relief around the turn of this year." His comments were seen as preparing markets for rate increases in 2016.
Instead, on Tuesday, Mr. Carney changed his tone, saying recent "developments suggest that the firming in inflationary pressure we had expected will take longer to materialize."
It was the central banker equivalent of humble pie. "Risks to the outlook and uncertainties about the economy are occupational hazards of monetary policy-making," Mr. Carney conceded. "That means we'll do the right thing at the right time on rates." Goodbye, forward guidance.
Here at home, Bank of Canada governor Stephen Poloz acknowledged that the bank had been leaning toward cutting the overnight rate almost right up until Wednesday's announcement that it was holding firm at 0.5 per cent – for now. It was a rare instance of Mr. Poloz erring on the side of tighter monetary policy, one that he attributed to expectations of coming fiscal stimulus from Ottawa. But the endlessly sinking loonie probably played as big a role, if not bigger, in the decision.
It could be short-lived. Like his chastened peers elsewhere, Mr. Poloz could be refilling the punch bowl soon. Their long-awaited exit strategy looks like wishful thinking.