Butterfly effect of policy rate movements

According to Scope “A senior official at the Japanese central bank stepped in to calm the markets, ensuring that it will not raise interest rates in times of financial instability”, Why a small increase in the interest rate of monetary policy causes a financial storm?

Interdependence is the key element of International Financial Architecture (AFI) to understand what is happening today in global financial markets. What happens in the economy or the economic policy decisions of a central country immediately impacts the rest of the global economy in a hyper-reactive way. Commercial and, mainly, financial interdependence It feeds back in speed and quantities in a more acute way than in the past.

In this changing scenario of the current AFI, central banks (even key ones in the G20 such as the Bank of Japan (BoJ) or the Fed) continue to make decisions in ways that do not always seem to take into account interdependence with the rest of the world.

Thus, a normal economic policy decision for a central bank like Japan’s is made on the basis of its domestic preference function between inflation, economic activity and financial stability, It generates strong repercussions in other markets such as Wall Street, Asia, Europe and Latin America, and very strong in certain sectors that lead a potential bubble, such as the technological sector.

The remarkable thing is that, in reality, We are talking about a rather insignificant (symbolic) increase in the monetary policy rate from 0.10% to 0.25% ANNUALLY which the bank carried out on an exploratory basis. So much so that the BoJ had to announce its decision to rethink the expected path of increase.

That small increase generated a overreaction with a strong appreciation of the Yen around 10% and an abrupt correction of the Tokyo stock market. Too much for a country like Japan, careful of its exchange rate competitiveness, with astronomical levels of debt in terms of GDP and an extreme demographic problem. A country that since the crisis of the 90s has been operating on a different frequency of economic policy.

The point is that, with such high interdependence, reasonable individual decisions by a central bank intersect with other events such as the abrupt realization in the market that the economic cycle in the US would be entering a recessive phase and that the FED took too long to lower the rate.

Both rate decisions will compress the returns of a large-scale carry trade activity that was developing with funding from the Japanese financial market and fueling asset inflation in the rest of the world (especially in technology companies that had a nice story to tell about the growth of AI and microchips).

These decisions, coupled with the behavior of opinion-forming financial players such as Warren Buffett and others who promote the sale of technology stocks and staying liquid, together with less promising than expected balance sheets of technology companies and the greater tension predicted in the Middle East, create favorable conditions for a disorderly correction.

Many believe that this is the beginning of a long process of dismantling the “carry” positions built up in recent years and in which all types of agents participate, not only highly leveraged speculative agents; but also long-term institutional investors and corporations.

We will see if the stabilizing speculators appear, who with cash They buy cheap what they sold dearly, and the markets correct themselvesor we are facing a deeper correction that requires urgent intervention by the FED. An option that it will try to avoid by all means, since it would be acknowledging that I should have done it last week.

Note that both the BoJ’s modification and the possible Fed hike are small, surgical. And yet, They generate storms that force central bankers to be excessively careful.who today are more concerned about not stepping into the minefield of financial stability than in moderating the cycle of prices, production and employment.

A possible answer to why small and even expected movements in policy rates generate financial turbulence may be found in the current configuration of the AFI based on: 1) full capital mobility, 2) the floating of central currencies, 3) a large and heterogeneous number of systemic financial entities with high leverage and low prudential regulation (especially those that are not banks and therefore escape the modest regulations of the G20, FSB, and Basel established after the global financial crisis) and 4) having accustomed the financial system for more than fifteen years to low global rates and quantitative easing that boosted speculative financial investments and that have a kind of put implicit.

The combination of these factors It hinders and conditions, in a way never seen before, the actions of the central banks that determine the functioning of the AFI.

Although nominally most central banks (not the FED) have a single objective, which is the inflation target, the obligation to care for financial stability has increasingly conditioned all decisions of the monetary authorities. As a result of these tensions, the interest rate instrument It is clearly over-demanded and requires resuming and deepening the global regulatory agenda that was semi-abandoned in the last decade.as the panic of the global financial crisis that began in 2007 faded into oblivion.

In the face of a global crisis, the current regulatory architecture is no better than the one that existed at that time, central banks are much more constrained in their use of the rate and have much larger balance sheets to make massive asset purchases. In other words, the room for manoeuvre of central banks has been reduced.