Hold your nerve in increasing volatility, central bankers urged

Extreme episodes of market volatility will become a more frequent feature of the global economy, the world’s leading central bank authority has warned, as investors grapple with shifts in interest rate policy.
The Bank for International Settlements noted recent financial turbulence, including a sharp drop in share prices worldwide at the start of August, and said that this would not be the last time that investors suffered from sudden swings in sentiment and a consequent mass selling of risky assets.
“It is part of the bigger picture,” Claudio Borio, head of research at the BIS, said. Upheavals in share markets were “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”.
The BIS, known as the central bank of central banks, 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 past three years. Now central banks are beginning gradually to loosen policy as inflation stabilises, with concerns about the state of growth and the labour market in the United States spooking investors this summer.
Borio said it was the job of ratesetters “not to overreact” to gyrations in asset prices and to 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.”
Share prices recovered their losses within days of the August sell-off, but signs of market stress have reappeared this month as investors digest data on the state of the US economy and its jobs market. Traders have begun speculating on the chances of an imminent American recession by stepping up their bets on an outsized interest rate cut of half a percentage point by the US Federal Reserve on Wednesday.
The BIS said markets were dominated by a binary model of “risk-off” trading, where investors fearing a potential recession 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, the BIS urged “prudence” from ratesetters 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.”