When will the effect of monetary adjustments be felt?

By Mohamed El-Erian

There is no doubt that developed countries will withdraw in the first half of 2022, albeit partially, the ultra-stimulant monetary policies that they have been applying in recent years.

What is more important, though less certain, is when and how this will lead to a significant tightening of financial conditions and what the spillover effects will be for the global economy. These topics are of interest not only to policymakers around the world, but also to businesses, households, and investors.

For US monetary policy, expectations have already changed dramatically. A little less than two months after the president of the Federal Reserve, Jerome Powell, “withdraw” the rating of “transientOn inflation, the consensus for this year has shifted to include an end to large-scale asset purchases, at least three interest rate hikes starting in March, and the start of central bank balance sheet shrinking.

This change came against a backdrop of persistently high inflation, including a 7% reading for the US consumer price index in December, and what some, like BlackRock’s Rick Rieder, call a “job market”.Red Hot”.

These changes have intensified in the last two weeks despite the increase in cases of COVID-19 due to the omicron variant, the economic slowdown in China and downward revisions to global growth prospects, including by the World Bank.

Some other developed countries, such as the United Kingdom, have gone further than the United States in reducing monetary policy stimulus. It is only a matter of time before others join the battle.

Although interest rates have started to rise, this notable change in monetary policy has not yet led to a significant tightening of general financial conditions. As a result, the real economy has yet to feel any contractionary momentum, markets remain relatively bullish, and developing countries have experienced few disruptive spillovers.

Various reasons have been proposed for the current disconnect between less accommodative monetary policy and relatively unchanged financial conditions, some of which are strengthening, others not so much.

One set of reasons relates to the willingness and ability of central banks to validate expectations of monetary policy tightening. Backed by years of experience, some experts predict that central banks will not have the stomach to go ahead with removing stimulus.

Others believe they will quickly be forced to make a U-turn as the economy, long conditioned by ultra-loose policies, struggles against a liquidity drain, and particularly as the Fed delayed its policy tightening too long and now has to group them into three contractionary measures.

A second set is based on the view that, given the relative magnitudes involved, what matters is the existing liquidity and not the reversal of the flow. Financial conditions will continue to be governed by the sheer amount of money flowing through the system rather than gradual policy changes.

It is a view that is reinforced by the fact that, despite the planned measures, the monetary policy stance for 2022 is likely to remain broadly accommodative.

The third set is more behavioral in nature. Given the multi-year conditioning of markets by more dovish central banks, it will take time to persuade investors to fully appreciate the new political realities. In this thinking, markets would need unequivocal and overwhelming evidence of a lasting change in policy before fully pricing it in.

Almost regardless of the reason, disengagement undermines the likelihood of timely and orderly adjustment, increasing the risk of policy error and undue damage to livelihoods. To assess this in the coming weeks and months, we are advised to:

• Look more at the evolution of fixed income than at equities to assess the degree to which financial conditions have begun to tighten.
• Focus on changes in short-term (up to five years) bond yields as a reflection of effective policy expectations rather than long-term ones, which are influenced by a much larger set of factors.
• Recognize that the economic impact will take time to become apparent and is likely to lag behind financial market developments.
• Appreciate that the adverse implications for developing countries are more important when (not if) the flow of capital to them is heavily reversed.

When some speak of the possibility of a new conundrum, it is important to recognize that the longer the disconnect persists, the more it may narrow what is already a small window for orderly policy, market, and economic adjustment.

Because the Fed reacted late to the pronounced shift in the macroeconomic paradigm—from poor aggregate demand to poor aggregate supply caused by fairly persistent supply-chain disruptions and labor shortages—the global economy faces a range of wide range of possible outcomes in 2022 and beyond. Now it also has to navigate a delayed and uncertain reaction to financial conditions.