London (CNN Business)Central banks were the superheroes of the early phase of the pandemic, taking dramatic steps to save the economy and financial markets from ruin.
Now, as the recovery kicks into gear, they’ve become a major risk for investors.
What’s happening: The latest reading of the Back-to-Normal Index from CNN Business shows that the US economy’s comeback is 90% complete. But investors are increasingly worried that the Federal Reserve, observing such promising data and rising inflation, will make a damaging mistake, such as moving too soon to roll back unprecedented levels of support — or ignoring growing problems until they’re too late.
In a Deutsche Bank survey of 620 market professionals published this week, 39% of respondents listed a “central bank policy error” as one of the top three risks to market stability, up from 21% the previous month.
Similar fears are reflected in the survey of global fund managers posted by Bank of America last week. The number two risk, behind inflation, is a “taper tantrum,” referring to a scenario where central banks ease up on bond purchases, increasing yields and sparking a panic in markets.
Big picture: Investors have become hooked on easy money from central banks like the Fed, whose decision to slash interest rates to rock bottom and buy up hundreds of billions of dollars in bonds fed the market’s rapid rebound after the initial coronavirus shock.
See here: The Fed’s balance sheet increased to $7.4 trillion last year, the highest level on record, according to a new report from the Federal Reserve Bank of New York. By 2023, it could grow to $9 trillion, it projects. That’s almost as much as the combined annual GDP of Japan and Germany — and means policymakers can’t afford to make a mistake.
After a long holding pattern, central banks are “waking up” to the risk of a “consequential financial accident,” Mohamed El-Erian, an adviser to Allianz and Gramercy, wrote Tuesday in an op-ed for the Financial Times. But they’re in a difficult position, he added.
For now, the Fed continues to hold firm its stance that it’s monitoring risks but does not intend to take near-term action, even as prices rise.
“There are reasons why we should be seeing higher price levels today,” Atlanta Fed President Raphael Bostic said Monday. “The question is how enduring is it going to be. Right now, I am not seeing it is going to be enduring.”
The European Central Bank is sounding slightly more cautious. Last week, it warned that while “the economy is still reliant upon policy support to prevent widespread unemployment, corporate insolvencies and economic contraction,” financial markets have “exhibited remarkable exuberance.”
El-Erian thinks that investors “should be encouraging the Fed to pivot rather than just focus on the continued joy of surfing the liquidity wave.” But breaking an addiction is easier said than done, even as the potential for negative complications add up.