After almost three years at the edge of the abyss, recent weeks have given rise to renewed optimism that the global economy is at last returning to stability. Stock markets across the world have shown new dynamism despite economic indicators pointing to sluggish activity in the US (with anemic job creation and manufacturing levels) and China (where industrial production is still weak due to declining export demand from the Eurozone). At a time of such gloomy economic data, what precisely has sparked such an improvement in investor sentiment?
Credit for this uptick can certainly not be attributed to any political headway. Election year concerns in the US have stalled any governmental measures aimed at stimulating employment, construction or consumer spending, and will continue to do so for the remainder of the year. Indeed, a report prepared by Moody’s, a credit rating agency, cited federal legislators’ doubts over upcoming negotiations to avoid a so-called “fiscal cliff” and find alternatives to severe expenditure reduction and tax cut expiration.In Europe, continued procrastination over a bailout for Spain’s distressed banking sector casts a long shadow over other countries such as Italy, Portugal and Ireland, whose fate is effectively tied with that of Spain.
Instead, institutions nominally outside the political arena have stepped forward. The German Constitutional Court, for instance, ruled that the establishment of the European Stability Mechanism, Europe’s permanent bailout facility, was consistent with the German constitution. Once formally implemented, the ESM will enable distressed sovereigns to access emergency funding without requiring further approval from reluctant neighbor states and provides the Eurozone with a €700bn firewall. The importance of this development is less related to the size of the fund, which most commentators agree would do little in the event of a Spanish or Italian bailout application, and more meaningful as a signal of Germany’s growing acceptance to cede economic sovereignty in certain circumstances.
Market enthusiasm at the removal of this final barrier to the ESM’s introduction was quickly overshadowed, however, by a groundbreaking announcement by Mario Draghi, President of the European Central Bank. Facing considerable opposition from the German Bundesbank, Draghi unveiled the Outright Monetary Transactions program, a new bond-buying scheme that enables greater secondary market intervention by the ECB while mandating participating countries to adhere to strict bailout-like restrictions. This program goes beyond the ECB’s previous schemes in that it will be, in Draghi’s words, without “limits for the amount of outright monetary transactions.” Without straying from the Bank’s strict adherence to price stability, Draghi continued to articulate the case for greater central bank intervention, but there are significant concerns over the future health of the ECB’s balance sheet given its continued relaxation of collateral rules.
Building on this momentum, Ben Bernanke launched the Federal Reserve’s latest stimulus program (“QE3”), which provided an open-ended commitment to purchase more mortgage-backed securities as part of quantitative easing. Citing the Fed’s mandate to facilitate full employment, the Fed’s move is designed to (1) increase downward pressure on interest rates and (2) encourage a rise in asset prices and personal consumption. Critics have cited a multitude of concerns with the scheme, from its dubious pre-election timing to the deteriorating quality of the Fed’s balance sheet. Nevertheless, stock markets spiked, with the S&P 500 now up 5.9% since August, and sovereign bond yields across the Eurozone receded from recent highs.
Perhaps the most immediate challenge facing monetary policymakers will be in managing expectations. At a time when interest rates are at or near zero, the Fed and ECB are concocting increasingly innovative ways to stimulate growth and keep markets satisfied. This will become unsustainable if and when price inflation re-emerges as a primary concern. The actions of this extraordinary week begin to show to waning influence of central bank interventions; at some point in the very near future, governments need to lead from the front.