INVESTORS CAN NO LONGER RELY ON A "POLICY PUT" / THE FINANCIAL TIMES OP EDITORIAL

Investors can no longer rely on a ‘policy put’

The capacity of policymakers to respond to shocks is down across the board

Mohamed El-Erian

While the willingness to shield markets may endure, the capacity to do so is less. Central banks cannot ignore the global inflation shock © Getty Images

For three decades, and some would argue longer, there has tended to be a recurring inconsistency between the policy principles of big central banks and actual practice when markets throw a tantrum.

Central bankers try to maintain a distinction between market sell-offs, which should be tolerated, and market malfunctions that threaten systemic stability and demand intervention.

Yet, when push has come to shove, they have tended to cross that line, deploying verbal intervention and policy measures, not just to address genuine systemic stress in the financial system but also to reverse simple equity sell-offs. 

This has sometimes happened even when the market plumbing was working well and the underlying real economy was sound, such as the fourth quarter of 2018.

In doing so, central banks routinely set aside worries about moral hazard, asset bubbles, and economy-wide resource misallocation in favour of the short-term comfort of a quick market rebound.

Governments have acted similarly, deploying massive fiscal packages to insulate households and corporate balance sheets from increasingly frequent and violent exogenous shocks (spanning the financial crisis, the pandemic, and the stagflationary fallout of Russia’s invasion of Ukraine).

For investors, this set-up established and reinforced a powerful conviction in the “policy put” — the implicit guarantee that policymakers possess both the willingness and ability to shield them not just from big losses but also unsettling volatility. 

This has deeply conditioned market psychology, with many investors viewing volatility not as a signal of fundamental developments, but as a virtually automatic buying opportunity.

This explains why equity sell-offs in recent years have proven spectacularly shortlived, regardless of the underlying catalyst. 

“Buy-the-dip” has evolved into a dominant, highly remunerative investment strategy. 

Consider how rapidly global equities recovered even after the initial shock of the Iran war, and the accompanying (and still ongoing) disruptions to critical energy corridors and global supply chains. 

US equity indices not only rebounded in a spectacular fashion but, since then, have gone from record to record.

Yet, an unyielding macroeconomic reality means this safety net should not be taken for granted. 

Facts on the ground — led by higher-for-longer inflation and interest rates, high debt and structural shifts in the global economy — signal tightening constraints on both fiscal and monetary authorities, compromising their ability to cushion future financial shocks.

While the willingness to shield markets may endure, the capacity to do so is less. 

Central banks cannot ignore the global inflation shock. 

Recent data releases showed US annual headline and core consumer price inflation outstripping consensus forecasts. 

As concerning, pipeline price pressures are surging. 

The monthly producer price index in April rose by an annualised rate of 6.0 per cent — the fastest one-month increase in the index since March 2022. 

Japan’s PPI data reflects a similarly troubling upwards trajectory, as do the latest figures out of Europe.

This inflation reality forces a stark choice between stabilising financial assets or protecting longer-term policy credibility. Furthermore, it risks accelerating “demand destruction” in certain economies from higher prices, and not just for energy.

Simply put, the room for countercyclical fiscal manoeuvring has evaporated across most advanced economies. 

The higher borrowing costs feed directly into larger government interest expenditures, while simultaneously threatening tax revenues as growth is hampered.

This fiscal vulnerability has awoken the long-dormant “bond vigilantes.” 

We are already witnessing their return and its impact on the more vulnerable sovereign debt markets of the G7, most notably in Japan and the UK.

The landscape for many developing economies is even more worrisome. 

Their use of fiscal and international reserve buffers to cushion external shocks is becoming exhausted in some cases, raising the threat of downward pressure on domestic living standards, capital flight and currency instability.

The global economy is now locked in an inevitably bumpy, structural recalibration. 

Given that policymakers cannot rely as much on old policy interventions, they will have to deploy other strategies — harnessing labour-enhancing AI adoption to drive genuine productivity gains, mobilising deep capital market financing, executing smart fiscal policy where space permits, and fostering far better international policy co-ordination.

For markets, such strategies are inherently less direct than a “policy put”. 

So investors will have to live with more complex structural uncertainty for a period of time. 

While an orderly end to the Middle East war would greatly help matters, it will take time for the global economy to regain the degree of policy flexibility to which markets have grown accustomed and, indeed, relied on.

The writer is the Rene M Kern professor of practice at Wharton School, chief economic adviser at Allianz and chair of Gramercy Funds Management