Central banks versus marketsThe ability to manage market expectations plays a critical role in the execution of monetary policy.
The Nepal Stock Exchange (NEPSE) is well off its lows from 2022. It is too soon to conclude if it is pricing in better economic fundamentals in the coming quarters. For now, the move could be technical. The index peaked at 3,227 in August 2021, followed by a 44-percent collapse through June 2022 when it tagged 1,807. Since that low, 1,800 attracted bids thrice—in September 2022 and May and November last year—even as rallies were sold just north of 2,200 in August 2022, January and July last year and again this January. On January 17, the NEPSE hit 2,215 and pulled back, dropping as low as 2,054 on February 4. The bulls need to defend horizontal support just north of 2,000.
Resistance at the upper end of the 1,800-2,200 range proved tough to crack. Once again, investors are beginning to look to the Nepal Rastra Bank for help. The central bank is preparing to deliver its semi-annual review of the 2023-2024 monetary policy—from mid-July to mid-January. The first quarterly review, released on December 8, lowered the risk weightage for banks’ margin loans above Rs5 million from 150 percent to 125 percent. This was preceded by an increase last October in the ceiling individual and institutional investors could borrow to Rs150 million and Rs200 million, respectively, from Rs120 million. This further helped placate grumpy investors.
Earlier, the 2021-2022 monetary policy—announced in July 2021—limited margin loan per customer to Rs40 million at one bank and Rs120 million at multiple banks. This essentially acted as a pin to prick the rampant speculation underway back then. Investors have since been clamouring to get the policy scrapped altogether. The Maha Prasad Adhikari-led Nepal Rastra Bank, until recently, pushed back—rightly—on these demands but has of late been loosening the restriction. Ahead of the semi-annual review, investors call on him to do away with it. It should be solely up to the bank to decide if the time has come to do so. Doing so under duress, however, will set a bad precedent.
Markets test central banks
Markets are constantly testing central bankers. The moment they know that the policymakers rush to acquiesce to the markets’ demands, they ask for more. Assured that the central bankers are there to lend a helping hand if anything goes wrong, investors/traders get spoiled and begin to take risks without fully understanding the extent of the risk—riding up the risk curve. Ultimately, this distorts markets, causing more dislocations and forcing authorities to hand out fiscal and monetary help. The cycle goes on and on. Nowhere is this phenomenon more evident currently than in the developed markets, particularly the United States. Being a budding market, Nepal can learn from their experience.
The Federal Reserve, the US central bank, is at a crucial juncture. To fight off economic malaise caused by the Covid-19 pandemic, it left the federal funds rate, which is the rate banks charge each other for overnight loans, near zero for two years. Easy monetary policy became the norm globally. Inflation began to perk up, with the US consumer price index surging at a four-decade high of high-single digits in June 2022. In March of that year, the Fed began to tighten, bringing the benchmark rates to a range of 525 basis points to 550 basis points by last July. It has now signalled that it is ready to ease—by 75 basis points this year. Futures traders instead have priced in a reduction by 150 basis points by December.
Markets are trying to bend Jerome Powell, the Federal Reserve chairman whose second four-year term expires in February 2026. He is resisting. This is unlike how his three predecessors behaved. Under Janet Yellen (2014-18), Ben Bernanke (2006-14) and Alan Greenspan (1987-2006), markets pretty much got what they wanted. This was a time when the 1987 stock market crash, the 2000 dot-com bubble and the 2008 financial crisis came about. Stocks would come under pressure, and the resultant wealth effect would impact consumer spending/sentiment. This is when the so-called “Fed put”, which is the idea that the Fed would not let the stock market drop beyond a certain threshold, was coined.
Bloated balance sheets
This time around, the dynamics are different. US stocks, sensing lower interest rates in the months to come, have rallied to record highs. Financial conditions have eased, raising risks of sticky inflation. Yes, US inflation is down to the three- to four-percent range but remains above the Fed’s two-percent objective. Powell understandably does not want inflation to resurge, hence is acting with patience. Markets are impatient; they want lower rates pronto—and much more than what they probably end up getting. Concurrently, central banks of the major economies will probably also consider their asset base, which remains bloated thanks to years of balance-sheet expansion to flood the system with liquidity.
In Japan, the Nikkei Stock Exchange is nearing the highs set in 1990. Investors are betting that the Bank of Japan would continue to delay plans to end its ultra-loose monetary policy; the bank—unlike its peers like the Federal Reserve, the European Central Bank and the Bank of England—still has its benchmark rates in negative territory and sits on a balance sheet that is 130 percent of Japan’s gross domestic product. Going forward, because they are sitting on loads of assets already, these banks should increasingly find it difficult to use balance sheets as an unconventional tool, with interest rates being the conventional tool. This will be a departure from how things were done for years this millennium.
Markets so used to receiving policy goodies the moment a financial crisis crops up are likely to find this volte-face shocking initially. This is the result of years of hand-holding by central banks. Hindsight is always 20/20, but they should never have gone down this path to begin with. But they did, and the result is high levels of sovereign debt, deficit financing, and asset bubbles, particularly in the US. Central bankers of countries like Nepal should treat this as a lesson in what not to do. The ability to manage markets’ expectations plays a critical role in the execution of monetary policy. In the end, it is the central banks that need to call the shots, not the markets, as the latter is focused on its own gains, not the nation’s.