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The Price of the Calm After the Storm

Markets are calm this August. Policy makers have ensured that, but distortions are rife.

As central bankers prepared for their annual summertime mountain gathering a year ago, a storm was raging in global markets. This year, conditions are much calmer. The power of policy has prevailed, but at a cost.

Last year’s panic came from China. The country’s poorly-communicated currency depreciation, accompanied by tumbling commodity prices, generated fears of a deflationary tide sweeping through economies. The Shanghai Composite Index fell 26% between Aug. 14 and Aug. 26, while the S&P 500 fell more than 10% in just four trading sessions in late August. High-yield bonds got battered; Treasury yields fell.

This year, the challenges haven’t stopped coming. From Brexit to a coup in Turkey and the continuing rise of populist politics, investors have had plenty of reasons to be anxious. But markets seem unconcerned. The VIX stock-volatility index has touched a two-year low; 10-year Treasury yields in August have moved in their narrowest range in more than a decade, Deutsche Bank DB -0.43 % notes; the S&P 500 has hit a new high.

Central banks eased concerns about the deflationary threat even as doubts persist about their abilities to do so. Rates have gone negative, and the Bank of Japan 8301 0.41 % and European Central Bank are wading deeper into markets. Perhaps most important, China has figured out how to stop exporting turmoil. A weaker dollar has made that easier.

The bullish case is that central bankers have given policy makers another opportunity to figure out how to boost growth and to deal with the legacy of past crises. Fiscal policy could offer further support; time will prove the great healer. Avoiding a renewed financial crisis is valuable.

The bear case is that misallocation of capital is rampant, and loose policy is taking the heat off politicians to make difficult reforms. For instance, as eurozone bond yields have fallen, governments have progressively implemented fewer and fewer of the policy decisions recommended by the OECD to boost growth, Standard & Poor’s notes.

Central banks now own a staggering $25 trillion of financial assets, according to Bank of America Merrill Lynch. Bond yields and prices are at extraordinary levels. The Austrian government bond due 2062 is trading over 200% of face value; the 10-year U.S. Treasury hasn’t yielded 3% in more than 2½ years. Central-bank buying has squeezed corporate markets; European nonfinancial bonds yield just over 0.5%. Single-B-rated Rwanda’s U.S. dollar bonds yield just 6.3%, down from 8.2% early this year.

Traditional relationships appear to have broken down. For instance, U.S. corporate leverage has been rising steadily, but this has been accompanied by tighter credit spreads, Citigroup C 0.32 % strategists note. Similarly, even as diverse financial markets have become more correlated with each other, often a sign of trouble, volatility has fallen. The fear is that negative rates are encouraging saving, not spending.

Investors now have a near-Pavlovian reaction to bad news: they expect monetary policy to ride quickly to the rescue. But central bankers are increasingly talking of the limits to their powers; they cannot address structural problems. Even if central bankers succeed in restoring growth, the real test will be unwinding the policies that bought the time to get there. After more than seven years of increasingly unconventional measures, the exit is looking increasingly difficult.

Write to Richard Barley at richard.barley@wsj.com

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