Global central banks are beginning to talk about the limits of policy and the need for complementary fiscal measures.

In the short term, markets do not like changes in the monetary policy regime. Indeed, even the possibility of such change can inflict serious losses. The best recent example of this was the “taper tantrum” in the late spring of 2013, when the mere discussion of an end to U.S. quantitative easing (QE) produced major losses in emerging and other risky markets. So the short-term risks of a policy change are certainly present.

Central banks contemplate the limits of policy

At a deeper level, it has become clear that something is changing in how central banks are considering their policy decisions. There is a broadening discussion of the adverse effects of negative rates, of limits to monetary policy, and of the need for complementary policy actions by governments. In a sense, we seem to be closing the chapter on the era of unlimited support from central banks and only from central banks. As the contours of the changing environment become clear, we should expect some hiccups in the markets.

But we do not believe investors should overestimate these changes. First, the global growth outlook remains just okay. It is hard to see real upside growth surprises anywhere in the developed world, and while some of China’s short-run indicators have improved we think the risks in China are clearly to the downside.

Secondly, central banks are not necessarily making radical changes. If the Fed really does hike rates in December, for example, it will likely be on a slow pace of 25 basis points per year. And the dynamic with the dollar remains in play: When the prospects for monetary policy divergence rise, the dollar appreciates, undercutting the need for the Fed to hike.

Mixing policy change with fiscal change

The one major development to consider now is the possibility of a change in the mix of monetary and fiscal policy. People are talking about this in the United States, but any fiscal impulse here will likely be small. In the United Kingdom and Japan, however, the possibilities are greater. The Bank of Japan’s (BoJ’s) latest moves have opened the door for the government to act. In the UK, the new conservative government clearly has embarked on a path of relaxing its self-imposed fiscal constraints.

Consequently, then, the environment for risk is changing. There is uncertainty over the U.S. presidential election — and the increasing potential for a Democratic sweep of the presidency and congressional elections. There is also market uncertainty with regard to the future policies of the Fed, the ECB, and the BoJ. In general, once these short-term uncertainties pass, we think the environment is likely to remain benign for risky assets.

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Global monetary policy is beginning to change. How much will risk assets suffer once the paradigm shifts?