Good intentions paved way to market mayhem
As hard as policymakers have sought to assure markets that they stand at the ready when conditions weaken, lack of a consistent voice has only spurred weakness, according to an analysis released Monday.
Emerging market economies are in turmoil as the Federal Reserve and its counterparts around the world look to unwind all the largesse of the past four-plus years.
Though economists are almost universally dismissing the impact of these smaller countries on U.S. growth, Wall Street is clearly on its heels after the worst January in years, and recent economic data show the recovery remains uneven at best.
A paper from Citigroup suggests that one of the reasons for economic turmoil—in developed as well as emerging markets—is because policymakers haven't figured out how to properly use the tools at their disposal.
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Stated another way, now come the consequences of a looming exit from ultraeasy money policies, and the picture so far isn't pretty.
The analysis from a team led by William Lee, managing director of the global chief economist team, and others offers some insight into the problems central banks in particular face for the road ahead:
Monetary, fiscal, and regulatory policy makers globally have had to discard historical practices and become more discretionary, politically contentious, and interventionist. On net, these policy developments collectively have heightened global uncertainty even as the recovery muddles along.
The Fed has been at the global forefront of monetary easing, expanding its balance sheet to more than $4.1 trillion in an effort to spur liquidity by buying up Treasurys and mortgage-backed securities.
But the central bank is looking now to exit the program through a process the market calls "tapering"—or the gradual withdrawal of the purchases. Market expectations are that the stimulus program, known as quantitative easing, will be finished by the end of the year.
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That, though, will leave the Federal Reserve with another challenge. Janet Yellen, the bank's new chair, hopes to control market expectations through "forward guidance," or providing benchmarks the Fed will follow before it begins further tightening through interest rate increases.
Its communication strategy has been less than stellar, however. A misstep last summer by former Chairman Ben Bernanke left the markets believing that tightening would come sooner than expected, while recent trends have shown that the Fed almost certainly will have to abandon its 6.5 percent unemployment rate target for beginning to consider interest rate hikes.
It is the uncertainty of this process that seems to have roiled developing countries, about which the Citi analysis expressed concern:
With the anticipated end of quantitative easing, credible forward guidance is all that will be left in the Federal Reserve's unconventional toolkit. It is obvious that more practice is required with this instrument before we retire quantitative easing. Meanwhile, global markets must learn to be more vigilant, and other central banks (especially in emerging markets) must learn to calibrate appropriate responses as their exchange rates and capital flows are buffeted by this uncertain environment.
The end result, Lee wrote, is that policy uncertainty—both monetary, from the Fed, and fiscal, through other government officials—is stifling global economic production.
Using its proprietary Economic Policy Uncertainty index, Citi estimated that business investment was reduced by 57 percent in the U.S. and 36 percent in Germany because of misgivings about the direction of policy and its ramifications.
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In its place came a business strategy that took advantage of ultra-low rates and high liquidity. Instead of plowing money into expansion and employment, businesses simply spent more than $1 trillion on stock buybacks and dividends to boost stock prices—rewarding a small group that holds equity stakes but penalizing the larger group that would have benefited through business expansion.
Growth has benefited from better consumption and housing demand, but investment spending as a share of (gross domestic product) has not recovered to pre-recession levels despite highly stimulative financial conditions that include "once-in-a-generation" low levels for global interest rates. Unless investment reverses its recent sharp decline, the likelihood of improving productivity growth to support higher wages and incomes diminishes, along with the hope for more robust sustainable long-term growth. In response, economic policy makers geared up with new approaches and policy tools to try to forestall such a dismal outcome. Unfortunately "no good deed goes unpunished," as the unintended consequences of their efforts may have inadvertently worsened the investment decline.
Ultimately, the problem with the Fed's QE is that no one really knew what would happen when it ended because the world has never taken monetary easing this far.
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Citi winds up its analysis with a fairly grim summary of how much financial engineering may have hindered the post-crisis economy.
Since 2008, muted investment along with a tepid recovery has spawned proposals for more activist and demand-bolstering policies. Unfortunately, substantial evidence suggests that investment has been weak because of the dizzying array of unusually active policy measures implemented in the United States, and the anxiety-provoking anticipation of reform measures in Europe since the crisis. With growing uncertainty about the outcome of these unprecedented policy changes, investment plans were delayed or canceled, and aggregate demand faltered. Indeed, it is time to amend the old maxim that "the path to Hell is lined with good intentions and unintended consequences."
The evidence presented here implies that doing less, or at least being more predictable and credible in what is to be done, may be the best remedy to ease the headwinds restraining investment. Otherwise, sizable changes in interest rates, inflation, and GDP growth will be required to offset the uncertainty-related headwinds generated by the otherwise well-intentioned policy initiatives.
—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.