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As Central Banks Pull Back, Market Uncertainty Rises -- WSJ

23 Jan 2018 7:32 am
By Tom Fairless 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (January 23, 2018).

The tide of easy money that lifted advanced economies out of recession will recede in earnest in 2018, opening a new phase in the global economic expansion.

From Frankfurt to Tokyo, central-bank officials are seizing on stronger economic indicators, including tentative signs of higher inflation, to signal an exit from aggressive stimulus policies that were rolled out after the global financial crisis. Asset purchases by the four major central banks -- the Federal Reserve, European Central Bank, Bank of Japan and Bank of England -- will shrink by more than 70% by the end of 2018, to around $50 billion a month, after peaking at $182 billion in March 2017, according to Deutsche Bank. And some banks are planning or signaling possible interest-rate increases this year.

The coordinated retreat by some of the biggest buyers in global financial markets raises the prospect of increased volatility and a possible correction in asset prices. Adding to the uncertainty, the generation of central bankers who handled the crisis is stepping aside, and it's unclear if their successors will share their desire to continue with aggressive monetary stimulus to support global growth.

Some central-bank officials worry that investors are failing to price in the new policy course, and may get hit hard. Meanwhile, there may be tougher times ahead for business and consumers, who are currently benefiting from ultralow borrowing costs.

"It is indeed surprising that long-term interest rates are now lower than they were in the summer, although growth has surprised very positively and growth and inflation forecasts have been adjusted upwards, " Yves Mersch, a member of the ECB's six-member executive board, told German reporters in an interview published on the ECB's website in late December. "It doesn't really follow."

Are times too good?

The policy reversal from major central banks comes as economic growth accelerates and inflation starts to approach targets after years of staying below projections.

Growth accelerated in about three-quarters of all countries last year, the highest share since 2010, the International Monetary Fund said in December. In the U.S., growth recently hit a three-year high of 3.3%, while the Fed's preferred inflation measure climbed 1.5% on the year in November, up from a 1.4% rate over the previous two months.

Higher U.S. inflation is a key risk for stock markets, because the Fed would likely raise rates more quickly than expected to cool the economy. Outgoing Fed Chairwoman Janet Yellen has suggested repeatedly that the period of weak inflation is likely to prove temporary.

The Fed has projected another trio of quarter-point rate rises this year and two more in 2019, but some investors think it might act more aggressively given strong growth and the likely additional economic boost from recent tax cuts.

In the eurozone, the ECB signaled on Jan. 11 it might move sooner than expected to phase out its giant bond-buying program, surprising investors and sending the euro higher. The change of course comes amid a sharp rebound in the eurozone economy, where business and consumer confidence are at their highest levels in more than 17 years. Average inflation, at 1.4% in December, remains too weak for the ECB to raise rates, but it is expected to edge up over the coming months and recently hit a five-year high in Germany.

German 10-year government-bond yields have started to edge up since mid-December, a possible harbinger of higher market interest rates.

In the U.K., the Bank of England raised rates in November for the first time in 10 years in response to higher inflation, and officials have signaled more rate increases could be coming.

In Japan, too, inflation is edging up. Core consumer prices, excluding volatile fresh-food prices, rose 0.9% in November from a year earlier, up from 0.8% in October. Bank of Japan Governor Haruhiko Kuroda has said he expects companies will soon start passing the higher labor costs that stem from worker shortages on to consumers.

"This is the first time since the end of the 1990s that such positive developments are being observed in Japan," Governor Kuroda said in a speech in Zurich in November. "The labor market is very tight, at virtually full employment, [while] inflation excluding fresh food and energy has been positive as a trend for about four years."

While major central banks have done all they could to push up consumer-price growth, which has lingered below target in recent years, a sudden increase in inflation would force them to change course, which could prove destabilizing for financial markets and the world economy.

"What is unthinkable today is [higher] inflation [in the U.S. and Europe], that's what scares me the most," says one top ECB official. "Markets would react incredibly."

Easing up

Another concern is the debt market. In response to record-low bond yields, global debt issuance by companies and governments reached a high in 2017, with U.S. and European companies particularly active.

But on the demand side, purchases by the ECB under its giant bond-buying program fell by half this month, and that flow of money could dry up entirely by October. Meanwhile, the Fed is gradually reducing its $4.5 trillion balance sheet, and the Bank of Japan has slowed its asset purchases and is hinting at an exit from easy money.

All of which raises the prospect of an "enormous mismatch between supply and demand" in global debt markets this year, according to Torsten Slok, an economist with Deutsche Bank in New York.

Central-bank officials hope their large stock of assets means market interest rates will rise only gradually. But some investors worry about a sharp correction given the mismatch between supply and demand of bonds, particularly as markets have so far been slow to adjust to the new direction of central-bank policies.

"There is a regime change in what central banks are trying to tell us," says Mr. Slok. "Investor sentiment could change suddenly."

Mr. Fairless is an editor in The Wall Street Journal's Frankfurt bureau. Email tom.fairless@wsj.com.

(END) Dow Jones Newswires

January 23, 2018 02:32 ET (07:32 GMT)

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