EL-ERIAN: The Central Bank 'Pharmaceutical Company' Has Brought An Untested Medicine To The Market

For many, central banks act in mysterious ways. Yet these enigmatic institutions have emerged as THE leaders in economic policy formulation around the world.

More accurately, central banks have been pushed into a role that they did not seek and that they are less than fully equipped to deliver on. And their impact is significant. Just witness how the Bank of Japan’s U-turn is realigning the pecking order in markets, shaping new political narratives, and making “experts” revisit many of their priors.

You should have no doubt. From the security of your job to the wellbeing of your 401K, and from the safety of your financial savings to the value of your home, central banks are touching you in multiple ways.

This reality will get more intense in coming months. But its ultimate outcome is also quite uncertain. So here are a few things to remember:

• Despite having already ventured deep into the uncomfortable unknown, central banks find it extremely difficult to step back. If anything, the trend is to do more.
• The longer any individual central bank stays in the current experimental mode, the higher the likelihood that others will be forced to follow suit (even if, in some cases – particularly in developing countries – domestic conditions do not warrant it).
• Central bankers feel they have no choice but to use blunt and imperfect instruments. As such, they are the first to acknowledge that their hyper policy activism involves a very delicate balance among “benefits, costs and risk.”
• So far, macroeconomic outcomes have consistently disappointed, and not just in absolute terms but also relative to central bankers’ own expectations.
• While central banks reduced the probability of disruptive tail events, they are yet to deliver on the growth and employment objectives.
• This is far from a first best for central banks. In the process, they have become hostage to the inactions of others (U.S.) or enormous political pressures (Japan).
• Despite all this, central banks have been the markets’ best friend.
• Higher asset prices are a critical component in the transmission mechanism linking policies to ultimate economic objectives. As such, investors have been conditioned to respond enthusiastically to central bank stimulus.

In enjoying the ride on this huge wave of global central bank liquidity, investors should not lose sight of two key elements:

• The increasing scale and scope of the collateral damage and unintended consequences of unconventional monetary policies; and,
• Over the longer-term, the still-unanswered (yet critical) question of whether central bankers will succeed in engineering a handoff from “assisted growth” to “genuine growth” or, instead, see their experiments end up in tears.

We all want central banks to succeed in promoting economic growth and enhancing job creation. There is a lot at stake, for both current and future generations.

Such success would also allow for economic and company fundamentals to validate current artificial pricing in many market segments.

Should success prove elusive, however, the major investment theme will pivot quite suddenly: From the benefits of riding the huge liquidity waves to the urgent importance of minimizing exposure to collateral damage and taking advantage of the inevitable market overshoots.

In closing, remember this simple analogy: Central banks these days are like a pharmaceutical company that feels compelled to bring to market medication that has not been clinically tested. In eagerly taking the medication, investors should focus not just on the immediate upside and its durability, but also on the longer-term impact of potential side effects.