Purpose of the article: This article aims to highlight the effects on financial asset markets of the monetary tightening and « normalization » initiated by the major central banks in 2022. Beyond the « mechanical » impact of interest rate hikes, we will emphasize the importance of the loss of the « central bank put » as a result of the reduced room for maneuver available to monetary authorities in a context characterized by the fight against excessive inflation.
Summary:
- Faced with inflation levels not seen in Europe and the United States for nearly 40 years, most major central banks have been forced to abandon the accommodative policies that have been in place for a decade and were amplified during the COVID-19 crisis.
- These policies enabled financial markets, the real economy, and governments to benefit from particularly favorable financing conditions and strong support from central banks when needed.
- Sustainably favorable financial conditions have supported financial asset prices, while countercyclical policies implemented by central banks in the event of financial stress or economic slowdown have smoothed the economic cycle and limited financial market volatility.
- The monetary tightening in effect since 2022 has resulted in particular in higher interest rates, which have had a « mechanical » impact on the valuation of financial assets.
- With their room for maneuver limited, central banks—grappling with excessively high inflation—have fewer options for intervention in the event of financial crashes or economic slowdowns.
- The loss of the » central bank put » is therefore not only likely to accentuate the effects of the economic cycle and the volatility affecting financial markets, but could also lead to the development of an economic and financial crisis that would not be hindered or mitigated by the actions of the monetary authorities.
In retrospect, the 2010s were generally a golden period for financial markets in developed countries. Like the economy as a whole, they benefited overall during this period, and until the end of 2021, from artificially and sustainably favorable financing conditions thanks to the actions of the major central banks (notably the Federal Reserve (Fed) in the United States, the European Central Bank (ECB) in the euro zone, and the Bank of Japan (BoJ) in Japan).. However, the sharp acceleration in inflation observed since 2021 (particularly in the United States and Europe) has led the monetary authorities of the major developed countries (with the notable exception of Japan) to « normalize » and « tighten » their policies[1].
In principle, monetary policy tightening results in an increase in central bank policy rates[2]. Normalization consists of abandoning the intervention tools that have made it possible to ease financing conditions beyond what conventional monetary policy allows (mainly through lower key interest rates) and thus increase support for the entire economic and financial system.
This article aims to highlight the effects of this change in monetary policy on asset markets, with a particular focus on the importance of the potential loss of the » central bank put » (CBP).
1) The direct and indirect effects of accommodative monetary policies on financial asset prices
1.1 Drivers and limitations of unconventional monetary policies
To deal with the 2008 crisis, the eurozone crisis (in the early 2010s), and more recently the COVID-19 crisis, the major central banks have developed and used « unconventional » intervention tools. In order to be able to ease financial conditions beyond what is possible with conventional approaches, monetary authorities have implemented asset purchase programs—or quantitative easing (QE)—and favored the use of forward guidance (FG). These tools have provided direct support to financial markets and governments’ financing capacity at a time when key interest rates had already reached their lower bound, i.e., in principle 0% for the main refinancing rate ( zero lower bound (ZLB) situation).
QE essentially consists of purchases of sovereign debt securities, which have had the direct effect of weighing on medium- and long-term benchmark interest rates, with short-term benchmark rates already compressed due to the ZLB situation. Forward guidance (FG) consists of the central bank announcing its intentions and future actions in advance with the aim of influencing the expectations of economic agents and the actions of market operators[3].
The prolonged use of these instruments (ZLB, QE, FG) over the last decade has helped to support the real economy, financial markets and the financing capacity of governments. However, these sustained accommodative policies are not without their drawbacks. In particular, they are likely to cause inflation to accelerate (as a result of the increase in the money supply) and increase the risk of financial instability, while artificially supporting financial asset prices.
To understand this last point, we must first explain the principles that make accommodative policies de facto supports for financial markets. In particular, we will highlight three transmission channels that cause unconventional intervention tools to interact with the valuation of financial assets. We will then be able to deduce why abandoning these instruments weighs on the markets, highlighting in particular the importance of the « central bank insurance » effect.
1.2 Direct and « mechanical » effects of supporting financial asset prices
Academic literature has established that unconventional policy tools have not only been effective in easing financial conditions and limiting the effects of crises (Bernanke, 2020), but have also had an effect on financial asset prices (Swanson, 2020; Couture, 2021).
We propose to highlight three principles which, from an investor’s perspective and in the case of accommodative monetary policy, mean that unconventional intervention tools influence the price of stocks and bonds and thus support financial markets.
The first effect on the price of financial securities is economic. Low interest rates stimulate the economy as a whole and thus increase the expected economic profitability of companies. This is because investments will then be less expensive to finance and the outlook for business activity will be better. All other things being equal, this results in improved profit expectations, which will tend to increase the market value of stocks (improved earnings per share outlook) and bonds (reduced risk premium or lower credit spread ).
The second effect is financial. Asset pricing models are based in particular on the discounted value (or present value) of future cash flows. A fall in benchmark interest rates « mechanically » increases discount rates and thus « mechanically » increases the present value of dividends (equities) and coupons (bonds) to be received and, consequently, the valuation of financial securities.
While the first two channels through which accommodative monetary policy influences financial asset prices are relatively direct or « mechanical, » the last effect presented is more related to an implicit insurance effect.
1.3 The indirect « central bank insurance » or » central bank put » effect
The third effect is linked to the « insurance effect » provided by central banks through their FG and their experience of past interventions. As noted by Thiemann (2021), « central banks now act as a safety net when disruptions arise, serving not only as lenders of last resort for banks, but also as market makers of last resort and investors of last resort for all financial markets. »[10]
By providing visibility to financial markets (via the FG) and « assuring » them of their ability to intervene (via asset purchase programs in particular) in the event of stress or major crises (as was the case in 2008 and 2020), central banks offer a kind of insurance to investors by reducing the risk they bear. This insurance can be considered an implicit protection option defined by the term » central bank put » (CBP).
Furthermore, the rapid responses of monetary authorities (particularly the Fed, the ECB, and the BoJ) during major financial shocks or temporary stress (as illustrated by the Fed’s shift and then interruption of its normalization policy following the financial market downturn in the last quarter of 2018, see Appendix 1) contrast with their reluctance to tighten financial conditions during periods of market growth or even euphoria.
This asymmetry in the response of central banks, which are likely to react promptly in the event of financial stress without responding symmetrically to periods of strong growth, lends credibility to and confirms the existence of a CBP in the eyes of the financial markets (see Appendix 2 for a summary of the article by Cieslak et al. (2020) focusing more specifically on the « mechanics » of the « Fed put » and its consequences).
As noted by Issing (2021), this asymmetry can also be observed in the response of central banks to changes in economic activity. Thus, « most central banks seem to follow a strategy of reacting quickly and decisively in the event of an economic slowdown, but only reluctantly and very moderately when the recovery gains momentum. »[12]
All other things being equal, this « free » insurance increases the value of securities for investors and therefore their price by reducing the risk involved. This is the third, indirect effect of accommodative monetary policies on the price of financial assets.
2) The inevitable return of the economic cycle and volatility
2.1 The direct recessionary effects of rising interest rates on the equity and bond markets
Since 2021, the return of high inflation (particularly in the United States and Europe, where price increases are well above the +2% target) has acted as an economic constraint on central banks, whose mandate includes fighting for price stability. To do so, the Fed and the ECB in particular are obliged to adjust and tighten their monetary policy, starting with normalizing it. In practice, this means abandoning asset purchase programs (ending QE) as a prelude to raising key interest rates (exiting the ZLB).
Unlike the period of normalization carried out by the Fed between 2014 and 2018, when inflation remained sluggish, the Fed and the ECB have lost their room for maneuver and are acting without any real latitude to reverse course in the event of major shocks. Faced with the need to tighten financial conditions to combat inflation while avoiding an economic and financial crisis( a possible consequence of monetary tightening when the economy is slowing down), monetary authorities are forced to « navigate by sight » and more or less abandon the use of forward guidance.
Indeed, in order to be able to provide forward guidance, it is first necessary to have a clear course and to know where one wants to go. By pursuing two objectives that require contradictory courses of action – namely, curbing excessive inflation, which requires monetary tightening, while at the same time avoiding an economic and financial crisis, which would require the opposite course of action in the short term – monetary authorities are no longer fully able to plan ahead.
Since the beginning of 2022, the equity and bond markets have logically declined in tandem, reflecting the consequences of past and expected interest rate hikes by the major central banks and the abandonment of asset purchase programs (QE). This tightening of monetary policy has led to an increase across the entire benchmark interest rate curve.
As a result, this movement has a recessionary effect, not only on economic activity, but also on traditional asset markets (equities and bonds) through the two direct transmission channels described above.
2.2 From the loss of the « central bank insurance » effect to the risk of crisis
Caught up in the reality of inflation approaching or exceeding +9% in Europe and the United States, and consequently deprived of room for maneuver, monetary authorities may no longer be able to provide a safety net for the economy and financial markets as they did during the last decade (a period when inflation remained sluggish).
The economy, which benefited in the 2010s from countercyclical monetary policies during periods of economic slowdown, may now have to evolve without the support of central banks. This situation could lead to a more pronounced return of the economic cycle, which accommodative monetary policies had helped to mitigate.
As in the real economy, the loss of the protection provided by central banks could also accentuate cycles and volatility in financial markets, which in principle reflect the anticipated state of the real economy. As a result, downturns may no longer be interrupted or mitigated by the intervention of monetary authorities, unlike what was observed during the last major financial crashes. This potential disappearance of the safety net provided by central banks justifies an adjustment of the risk premiums specific to the equity and bond markets and should therefore weigh on prices independently of the readjustment directly linked to increases in reference rates.
Furthermore, beyond the loss of free insurance (which should therefore be reflected in prices), the absence of CBT is likely to have major consequences for the financial and economic spheres in the event of a crash or crisis. Without monetary easing or supportive policy (asset purchases) to prevent or mitigate it, the onset of an economic and financial crisis would certainly have severe effects on the entire economic system.
Through a self-fulfilling effect, this threat is itself likely to cause severe turmoil in the financial markets if inflation remains high. In this case, the monetary authorities may have to choose between maintaining a determined policy to combat excessive inflation or crossing the Rubicon by offering the markets a safety net through further monetary easing. However, the latter choice would be likely to jeopardize the central banks’ most precious asset: their credibility. The loss of the CBT, which is probably both temporary and inevitable in the short term, could therefore prove extremely costly for both the economy and the financial markets.
Conclusion
Having become accustomed over the past decade to a sustained accommodative monetary policy and often dependent on the support of monetary authorities in times of crisis, the economy and financial markets may face a painful period of withdrawal.
Caught up in the economic reality of inflation, which is testing their credibility and their willingness to fight for price stability, central banks are being forced to act contrary to the countercyclical policies proposed in the 2010s by tightening monetary policy at a time when an economic slowdown is looming. Their actions are therefore already likely to accentuate the effects of the economic cycle (rather than mitigate them) and, as a result, increase the volatility of financial asset prices, which are supposed to reflect—albeit sometimes in a distorted way—economic fundamentals.
Mechanically penalized by the cycle of rising interest rates, financial markets and the economy as a whole could suffer even more from the loss of central banks’ room for maneuver. Forced to combat inflation that threatens to remain high for a long time and to propose a monetary policy in line with the current economic reality, monetary authorities may no longer be able to offer the safety net that took the form of massive interventions and significant monetary easing in the event of an economic slowdown or financial shock.
For financial markets, the loss of this free insurance, or » central bank put, » is bound to be reflected in prices. Beyond this adjustment, the risk lies primarily in the development of an economic and financial crisis (debt crisis, currency crisis, banking crisis) that would not be mitigated by central bank action.
Sébastien CABROL
Appendix 1: The aborted normalization of 2014-2019
December 2018. While the economic outlook remains solid, financial markets are experiencing a storm in the last quarter of the year, resulting in a sharp fall in equity and bond markets. Between early October and late December 2018, the S&P 500 index fell by nearly 20%, while the ICE BofA US High Yield Index (representative of the high-yield corporate bond market in the United States) fell by more than 5%.
The reason cited? A tightening of financial conditions, reflected in particular by the US 10-year yield once again crossing the 3% threshold. However, this tightening was deliberate and planned by the Fed, which, from the end of 2014, wanted to normalize the overly accommodative monetary policy that had been put in place following the 2008 crisis. To this end, the US central bank has gradually raised its key interest rate by 225 basis points over three years and has been reducing its balance sheet since 2017 (which had more than quadrupled since 2008).
The monetary authorities conducted this normalization phase by using their forward guidance to communicate their intentions in advance, with the aim of warning and preparing the financial markets for the consequences of a less accommodative monetary policy. The aim was to avoid a financial crash. By making it clear that this monetary tightening went hand in hand with an improvement in economic conditions and that, on the other hand, the possibility of reversing course if necessary still existed, the Fed sought to avoid triggering panic by assuring the markets of its support if needed.
The credibility of this assurance, or « Fed put, » was about to be put to the test. While in September 2018 the Fed was forecasting four rate hikes in 2019, in December it adjusted these projections to just two hikes. In the end, there were none, and the central bank reactivated its asset purchase program in August 2019.
This episode illustrates the difficulty of normalizing an accommodative monetary policy, even when there is room to maneuver. In the absence of inflationary pressure, the Fed had the leeway to adjust both its communication (signaling the possibility of reversing course if necessary) and the timing of its normalization policy. Despite this and a favorable economic environment, the Fed was unable to see its normalization attempt through to the end. Faced with market pressure, it was forced to revise its expectations, suspend its cycle of rate hikes and, ultimately, resume its asset purchases, marking the end of the normalization phase and a return to an overall accommodative policy.
This episode teaches us, first, that the financial markets’ tolerance for a normalization policy is limited, even when it is conducted with great caution; second, that when the financial markets find themselves in a period of stress, the Fed has effectively changed its policy, thus lending credibility to the existence of the « Fed put. »
While the Federal Reserve does have a duty to « promote financial stability and prevent bank runs, »[17] the adjustment of its policy from the end of 2018 onwards has mainly served to support financial asset prices. From this perspective, it is reasonable to consider that the Fed acted beyond its mandate on this occasion.
Appendix 2: Summary of the article by Cieslak and Vissing-Jorgensen (2020) on the functioning and mechanisms of the « Fed put »
Cieslak et al. (2020)[18] highlighted the Fed’s tendency to react asymmetrically to market movements. Thus, downward movements in financial markets appear to be an early signal of a forthcoming easing of monetary policy, without the reverse being true. According to the authors, the Fed tends to believe that a decline in financial asset prices could have a negative impact on consumption through a wealth loss effect.
Cieslak et al. (2020) note that this assurance inducesmoral hazard effects that can lead to excessive risk-taking by market operators and thus potentially threaten financial stability.
The authors emphasize that moral hazard effects can occur ex ante and ex post in relation to central bank intervention in the event of market stress. Ex ante, market operators could take more risks (or lower their expectations in terms of risk premium) considering that they benefit from a protection option. Ex post, accommodative measures, which affect interest rates, would make it possible to increase leverage at a lower cost, as the cost of leverage would have decreased.
Cieslak et al. (2020) note that the consequences of moral hazard effects did not have a significant impact on monetary policy, even though Fed officials—and ECB officials, according to Carré (2015)[19] —were well aware of their existence. It therefore appears that central banks consciously accepted the risk of increased financial instability in exchange for actions aimed at easing tensions in the financial markets.
[1] For an overview of the monetary policies of the main central banks, see in particular: Cabrol S. (2022), « How to explain the divergences between the monetary policies of the three main central banks, » BSI Economics.
http://www.bsi-economics.org/1424-minnute-bsi-3bqc-pol-mo-sc
[2] For more details on the principles of action taken by a central bank to combat excessive inflation, see in particular:
Cabrol S. (2022), « Our purchasing power is being eroded and central banks are looking the other way, » Forbes France.
[3] For a detailed description of unconventional intervention tools, see in particular:
Cabrol S. (2022), « Contradiction or normalization: central banks at a crossroads, » BSI Economics.
http://www.bsi-economics.org/1420-contradiction-normalisation-bqc-heure-des-choix-sb
[4] For a summary of the limitations associated with the prolonged use of unconventional intervention tools, see in particular:
Cabrol S. (2022), « Review of Eric Monnet’s book (2021), La banque providence, Editions du Seuil et de la République des idées, » Revue Esprit,no. 487-488, July/August.
[5] Cabrol S. (2022), « Contradiction or normalization: central banks at a crossroads, » BSI Economics.
http://www.bsi-economics.org/1420-contradiction-normalisation-bqc-heure-des-choix-sb
[6] Bernanke (2020) estimates that, depending on the circumstances (particularly when the neutral nominal interest rate is between 2% and 3%), the use of QE and FG can offset the effects of the ZLB and provide up to the equivalent of 3 points of monetary easing.
Bernanke B. (2020), « The new tools of monetary policy, » American Economic Review, 110(4), pp. 943-983.
[7] Swanson (2021) highlights in particular that unconventional policies (QE and FG) have a significant and lasting impact on stock and bond prices.
Swanson E. (2021), « Measuring the effects of Federal Reserve forward guidance and asset purchases on financial markets, » Journal of Monetary Economics, Vol. 118, March, pp. 32-53.
For a summary of Swanson’s article (2021), see:
Vaille M. (2022), « Quantitative easing and forward guidance: what effects on financial markets? », BSI Economics.
[8] Couture (2021) highlighted that a change in FG relating to the future level of key interest rates (less than two years) was likely to influence medium- and long-term sovereign rates.
Couture C. (2021), « Financial market effects of FOMC projections, » Journal of Macroeconomics, Vol. 67, March, 103279.
[9] In finance, the present value at time t0 – i.e., V(t0) – of a cash flow to be received at a future date T – V(T) – is the amount V(t0) which, when invested between t0 and T at the market interest rate corresponding to the maturity, has a capitalized value at date T equivalent to V(T).
For more details on financial asset valuation models and principles, see, for example:
Hull J. (2004), Options, Futures, and Other Derivative Assets,5th edition, Pearson France.
[10] Thiemann M. (2021), « The asymmetric relationship between central banks and market financing: an assessment of the implications for financial stability in light of Covid-related events, » Revue d’économie financière,no. 144, pp. 191-201.
[11] The same principle will be used to define the » Fed put » when considering only the Fed’s actions.
[12] Issing O. (2021), « New monetary policy guidelines: abandoning the anchor? », Revue d’économie financière,no. 144, pp. 123-131.
[13] For more details on the dilemma facing central banks, see in particular:
Cabrol S. (2022), « The European Central Bank faces the test of normalization, with the euro facing the risk of desynchronization, » Forbes France.
[14] Cabrol S. and Lequillerier V. (2022), « A dilemma for the ECB, » Le Monde, September 4, 2022.
[15] Schnabel I. (2022), « Monetary policy and the Great Volatility, » Speech at the Jackson Hole Economic Policy Symposium, August 27.
https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220827~93f7d07535.en.html
Lane P. (2022), « Monetary policy in the euro area: the newt phase, » Remarks for high-level panel « High Inflation and Other Challenges for Monetary Policy » at the Annual Meeting 2022 of the Central Bank Research Association (CEBRA), Barcelona, August29.
https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220829~b9fac50217.en.html
[16] Without the protection of CBT, the economic and financial system faces renewed uncertainty in a context where central bank action is no longer the miracle cure that can solve all problems. However, this new reality could also lead to a correction of some of the undesirable effects of overly accommodative monetary policies. By providing the economy and markets with unfailing support, monetary authorities have effectively offered a monetary rent and a « free option » to capital holders, at the risk of promoting bubbles and accentuating inequalities between those who hold wealth and those who do not.
[18] Cieslak A. and Vissing-Jorgensen A. (2020), « The economics of the Fed Put, » NBER Working Paper Series,no. 26894, March.
[19] Carré E. (2015), « The ECB’s unconventional monetary policies: theories and practices, » Alternatives économiques / L’économie politique,no. 66, pp. 42-55.
