Impact of Central Bank Policies and Intervention on Financial Markets

One of the most talked about topics in the financial industry right now is the deflationary environment in the US and the measures taken by the Fed to counter it. At the same time, many in the financial world are lauding the attempts of Japan’s Prime Minister, Shinzo Abe for his attempts to pull the country of its prolonged recession. However, there are many others who criticise such measures because of their inefficiencies to drive real economic growth. In order to understand the economic condition of any country it is important to liber ltd the objectives of central banks’ policies and the effectiveness of their tools which are implemented. From an investment point of view, it is really of prime importance to how these tools impact the market.

The monetary policies of a country pertain to the quantum of money supply and fiscal policies are related to the public finance of the country. Each country’s Central Banks along with its Treasuries try to manipulate the interest rates and money supply in order to control the economic activity and safeguard the national currency against extremities. Any mismatch in the currency’s valuation with the interest rate on borrowings will provide for a good arbitrage opportunity and the market will react to correct this. Also, since the financial markets are a subset of the entire economy of a country the policies have direct impact on the performance of the financial instruments as well.

Though there was considerable intervention by the central banks prior to 2008, the 2008-financial crisis has led to increased scrutiny of the financial markets by Central Banks. Various measures by the public authorities to revive the economic condition has only led the advanced nations in deeper into recession. This is mainly because the stimulus provided by the public authorities to propel economic growth has increased liquidity without an equivalent economic activity. This has driven the valuations in financial markets higher creating a deep disconnect between economic growth and financial markets. This disconnection between the economic activities and financial market movement can be corrected only if the markets are allowed to operate freely without the intervention of the central banks. However, in such a scenario, investors may loose both their expected returns and capital.

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