Hold your nerve in increasing volatility, central bankers urged

Extreme episodes of market volatility will become a more frequent feature of the world economy, the world’s leading central bank authority has warned, as investors grapple with major shifts in interest rate policy.
The Bank for International Settlements, known as the central bank of central banks, noted recent financial turbulence, with a sharp drop in global stock prices at the start of August, and said this would not be the last time that investors suffer from sudden swings in sentiment leading to mass selling of risky assets.
“It is part of the bigger picture … and the inevitable withdrawal symptoms that markets suffer as they transition away from the extraordinary period of exceptionally low interest rates and ample liquidity that has prevailed for so long,” Claudio Borio, head of research at the BIS, said.
The BIS has long warned of the fragility of financial market behaviour as interest rates have shot up from close to zero to multi-decade highs in the last three years. Central banks are now beginning to gradually loosen policy as inflation stabilises, with concerns about the state of US growth and the labour market spooking investors this summer.
Borio said it was the job of rate-setters “not to overreact” to gyrations in asset prices and keep their focus on using monetary policy to manage inflation rather than to comfort investors with rate cuts. “Allowing things to play out, as long as they do not become systemic, is clearly a good strategy to follow,” he said.
“It is a question of judgment but two principles are very important. One is to make sure that you keep your ultimate objectives very much in mind. Clearly, price stability and financial stability are key.
“The second is to make sure … that you try and differentiate as much as possible your actions designed to deal with the financial turbulence, on the one hand, and [those] designed to deal with your ultimate macroeconomic objectives, like price stability.”
Stock prices recovered their losses within days of the August sell-off but signs of market stress have reappeared this month as investors parse data on the state of the US economy and jobs market. Traders have begun speculating on the chances of an imminent US recession by ramping up their bets on an outsized interest rate cut of half a percentage point from the Federal Reserve on Wednesday.
The BIS said markets were dominated by a binary model of “risk off” trading, where investors who fear a recession is coming flee to safe assets such as the dollar and government bonds, or “risk on”, which drives up stock prices.
With the Fed poised to cut rates for the first time in four years this week, the BIS urged “prudence” from rate-setters as they start to reduce borrowing costs.
“If there is a silver lining to this inflation spurt, it is that finally there has been the room for policy manoeuvre and it would be a pity if this room for manoeuvre was squandered,” Borio said. “It is important that monetary policy operates with safety margins to deal with the expected and unexpected.”