Monetary policy creates fragility - Now policymakers have to solve the problem

There are a few concepts that everyone should takeaway from their economics 101 class. One, economic agents response to incentives. Two, there will always be unintended consequences when incentives are changed. Change the incentives and behavior will change. Unfortunately, we don’t always know what will be the behavioral change. Perhaps the greatest problem in economic forecasting is trying to figure out how behavior adapts when faced with new circumstances. 

Given the law of unintended consequences, any policy should be crafted with care for the simple reason that the market response will not always be clear. This is especially the case for financial markets where capital is fluid. Policymaker then have to adjust to the response by markets to their initial action. These thoughts are forefront in my mind after reading the IMF World Economic Outlook Report and Global Financial Stability Report.

Global economic growth is slowing and central banks are again responding through an aggressive monetary policy of lowering rates. There is now worry that rate cuts will be less effective than fiscal policy, but there is little questioning in the minds of central bankers for this need. 

However, reading the IMF Global Financial Stability Report describes an environment filled with financial excesses. In this world, low interest rates have been the fuel for excessive leverage and an ongoing reach for yield by investors that must be addressed with macro prudential policies to curb behavior.

Financial stability is affected by three factors: size, valuation, and vulnerability. While not at excessive levels in some sectors, non-financial firms, non-bank financing and sovereigns are all at elevated exposure levels at or above levels from the Financial Crisis. Valuation in both credit and equity markets are high, which increase risks to investors. The markets may not be vulnerable given relatively loose financial conditions, but any downward change in financial conditions will place the borrowers and lenders in a difficult state. 

Central banks lowered yields to offset the risks from the Financial Crisis, a balance sheet recession. Nevertheless, leverage has not declined but has actually grown over the last decade. Many firms have gone on a binge of borrowing sustained by savers willing to take on risks to offset low yields. Bank leverage may have been curtailed but alternative sources of funding have arisen to offset any bank void.

Now governments are suggesting more aggressive macro prudential policies to offset the effects of aggressive monetary policy. The incentives put into place caused a change in borrowing and lending behaviors which now have to be curtailed through new constraints.

Monetary policy is a blunt instrument  that can create fragility that now has to be solved with new policies imposed on the market. This is just the next phase of further financial repression. For investors, there is a need to assess sector risks and start to adjust risk positioning before financial fragility is discounted in prices.