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Summary

  • Since the financial crisis, there has been a greater focus on financial stability by global central banks.
  • The third mandate of central banks--financial stability--will be sacrificed at times for better economic performance.
  • Once the economic healing is completed, monetary policy has to play a different role where the third mandate has to strike a balance.

Since the financial crisis, there has been a greater focus on financial stability by global central banks. The aftermath of the crisis showed how leveraged, off balance sheet and opaque financial instruments can have a profound lasting impact on global potential output. As a result, many central banks have added a "third mandate"--namely financial stability.

This mandate may prove to be paradoxical at times. For one, if asset prices were to fall sharply, they may shake investor confidence and thereby impact the economy. Depending on how large the market dislocation would be, central banks having prided themselves on quantitative easing being effective in financial distress would likely deploy such policy again. However, quantitative easing has been subject to a debate of engendering financial instability. To have policy geared to using asset prices to boost the economy may not work that well the next time there is a major crisis.

For investors, that may mean that future returns in asset prices could be less influenced by central banks. Of course, that depends on the magnitude of a financial shock. However, like with earthquakes, an insurance premium only kicks in when there is substantial damage. In the current market environment, central bank involvement remains large, which is why there can be a slow "detachment" expected as economies gradually recover. That may also mean that to address risks of financial instability, blunt tools like hiking short-term interest rates can only be done in a modest fashion. The yield curve would express such with a flattening bias between short and long maturity bonds -- "shallow glide path," as Janet Yellen dubbed it recently.

The third mandate of central banks--financial stability--will be sacrificed at times for better economic performance. When an economy is stronger, it may, in the eyes of policy makers, warrant less vigilance on controlling risks in the system. Pundits would be dusting off the Hyman Minsky theory of financial instability hypothesis that simply states "stability" creates instability. Asset prices in general--whether stocks, bonds, currencies or commodities--will not forgive that easily. In the current market environment, the theme remains fortunately that of an economic healing across major developed economies. Asset prices have so far gone along, and that may result in new complex leveraged positions. Once the healing is completed, monetary policy has to play a different role where the third mandate has to strike a balance. Often that proves to be too late in timing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: A Third Mandate