The Fed confirms its move to forward guidance and permanent zero

Today’s commentary

Recently, I wrote a series of posts predicting that the Fed would give up on QE and move toward forward guidance in order to be able to normalize policy. Nevertheless, I have also been saying for quite some time I believe the US zero rate policy is ‘permanent’. There are big implications from this for markets, risk, asset allocation and banks. Yesterday, we finally got an extraordinary confirmation from two Fed papers that the Fed is indeed going for forward guidance. But the papers also indicated the Fed has moved toward a near-permanent zero rate policy due to the economic situation in the United States. 

Forward Guidance

First, let’s review the move from QE to forward guidance. In September I wrote about tapering and the shift from QE toward forward guidance. My thesis was as follows:

  • The Fed prefers interest rate policy as its primary policy tool. It is only using quantitative easing because it has hit the zero lower bound on rates.
  • Now that short rates are zero, the Fed believes it needs to extend its influence into longer-term rates for monetary policy to be effective.
  • The Fed exerts a dominant influence across the yield curve, not just on the short end via interest rate expectations
  • The Fed has two principal tools to influence these expectations: forward guidance and quantitative easing. Forward guidance is a form of ‘rate easing’ in that it targets longer-term rates via the Fed’s influence over the expectations channel. QE is similar buts acts through a quantity mechanism instead of a price mechanism
  • At some point this year, the Fed soured on QE as a policy tool. First, I believe it is ineffective because it targets quantity and not price when the Fed is an interest-rate i.e. price targeting monopoly supplier of reserves. Second, the increase in the Fed’s balance sheet has brought it untoward political attention that the Fed seeks to avoid. Third, there is no clear transition from QE to normalized interest rate policy and the Fed’s experience with tapering has shown any transition is likely to be volatile.

For all of those reasons, the Fed is committed to moving away from QE as a policy tool. The question is not whether, it is when. As the US economy has failed to reach lift off, the Fed’s timetable for tapering has moved back. But the desire to move to a forward-guidance centered regime is still palpable.

Permanent Zero

The Fed’s desire to normalize policy by moving away from QE, a quantity-targeting vehicle for influencing long rates, toward forward guidance, a price-targeting vehicle for influencing long-rates, is at odds with the likely duration of zero rate policy.

I have always believed zero rate policy would likely be longer than anticipated. If you look through the archives at Credit Writedowns, the first time you come across the term ‘permanent zero’ is in September 2010 in a post of mine on job guarantees. I wrote this regarding the situation in the US:

“I prefer fiscal policy over monetary policy. Interest rates are a blunt instrument. Permanent Zero, where we are now headed unless the Fed prints enough money to replace private credit, is toxic. For me, it is clear that easy money in the form of both excess liquidity and low rates leads bond market participants, many of whom have nominal rate targets in mind, to reach for yield. It is clear to me that retired investors rolling over fixed income securities must also reach for yield and risk if they want to secure a decent return to live on. It is clear to me that leveraged finance professionals pile into acquisitions when rates are low because the extra leverage they can get is like free money.

“There have been a lot of people denying the centrality of low interest rates to creating the bubble. These people obviously have never worked in the capital markets. If they had, they would have seen what low interest rates do to animal spirits and risk-seeking.”

Translation: Because the Fed is never going to be able to increase its balance sheet enough via large scale asset purchases to overcome tighter fiscal policy and the collapse in credit growth due to private sector deleveraging, zero rates are going to become near-permanent.

We needed perhaps $8-10 trillion worth of quantitative easing. And that amount of easing is not possible given the supply of Treasurys outstanding or the political climate.

The problem with permanent zero rates are asset bubbles, of course. Some economists deny any relationship between low rates and asset bubbles. But we have seen investors reach for yield based on flows into various asset classes like high yield, leveraged loans, emerging market debt and the spreads in those asset classes. This reaching for yield does spur some increase in credit, however, and that’s the Fed’s goal. Nonetheless, it results in a lowering of credit quality and an increase of risky loan terms, phenomena we have seen during this cycle. The Fed knows about these risks. And I am not just talking about Jeremy Stein, who spoke out on the ‘reaching for yield’ issue only earlier in the year. Janet Yellen, the next Fed chair, spoke about this issue three years ago in pointed terms. And William White, the former chief economist at the Bank for International Settlements, warned last year about the unintended consequences of ultra-easy monetary policy. So, the bubble risk is real.

But there is also another risk to easy money, carnage on bank balance sheets. As I pointed out beginning in 2010, Quantitative Easing and Permanent Zero are toxic to bank net interest margins. What happens is that as banks roll over their asset base, the yield curve flattens and net interest margins contract. This was already occurring in 2010, but is now much more advanced. As a result, the increase in bank accounting gains has come entirely from smaller charge-offs for bad loans and non-interest product. The FDIC has even pointed this out in the first paragraphs of its report on quarterly bank earnings again and again over the last couple of years.

The risk here is with low loss provisioning and diminishing net interest margins entering into a recession that demands high charge-offs for bad loans which made even more acute by a misallocation of resources induced by low rates. This is a recipe for a huge loss of bank capital, for declining credit availability, and fire sales. 

The Fed papers

All of this makes the two recent Fed papers interesting. Here we have specific confirmation that the Fed is embarking on the course I have told you was likely. And there are going to be large implications for bank earnings, asset allocation, asset prices and risk.

In the one paper by Fed economist William English (pdf here), we see an argument for lowering the threshold for rate increases to 5.5% instead of the present 6.5%. The argument here is that the situation today requires significantly more stimulus than a Taylor rule or the current thresholds for employment and interest rates imply. Moving the thresholds would mean rates would not rise until at least 2017, according to current Fed thinking about the economy. And note that this assumes an expansion which began in 2009 continues for eight years into 2017. This is an explicit argument for permanent zero. It is also an argument for increasing the Fed’s inflation target, something people like Ken Rogoff have been pushing.

In the other paper by David Wilcox (pdf here), we get a channeling of Janet Yellen’s argument that the Fed must ‘pre-commit’ to keeping rates lower for longer i.e. permanent zero. And the reason is a basic hysteresis argument, in which the poor economic climate of today has a residual impact on the economic climate of tomorrow, making it urgent to normalize the economic climate quickly. Yellen said specifically, “Although I view the bulk of the increase in unemployment since 2007 as cyclical, I am concerned that it could become a permanent problem if the recovery were to stall.” And what she meant was that what was a cyclical unemployment problem, could through hysteresis, become a permanent structural problem. She believes the Fed must be overly-accommodative in order to prevent this. Wilcox lays this argument out in detail

Now, Fed watchers believe that both of these papers, which have been in the works for months and are the product of two top, well-known Fed economists, have to have been endorsed by both Ben Bernanke and Janet Yellen. So they represent an almost de facto Fed policy statement.

Goldman Chief Economist Jan Hatzius believes these papers mean that QE tapering will happen sooner than later and that they presage a move to reliance on forward rate guidance as the main policy tool. He also says that zero rates could remain in place until “the early 2020s”. 

Obviously, I agree with Hatzius. And it is interesting that the NY Fed has also recently put out research that claims forward guidance is an effective policy tool (pdf here). The author of this piece, Brian Sack is someone I have mentioned in the past because he enjoys high credibility in policy circles. His thinking on how QE works as a policy tool was very influential.

Implications of the new regime

I believe this new regime has a number of implications for markets listed below. But, note that we are just getting the intellectual justifications for the future policy regime shift. The details of the policy are to be determined. In September I laid out some rough guidelines on what kinds of rules we can expect. I have already indicated, however, that, to increase forward guidance’s effectiveness as a policy tool, I believe a Yellen Fed will take a rigid rules-based approach and move away from the haphazard approach that has marred the Fed’s communications strategy since tapering talk began. So let’s look for signs that the Fed wants to set these thresholds in stone and stick to them. After all, the suggested move down to a 5.5% unemployment trigger would be a shift that could undermine credibility because it introduces time inconsistency as an overt problem which will induce the market to front-run Fed policy and make it less effective.

Here are the market implications:

  • The U.S. is now in a permanent zero rate interest rate policy environment that will anchor not just short rates but long rates.
  • As the forward guidance tool set takes form, it will more explicitly shape long-term Treasury rates and flatten the term structure of yields. Longer-duration Treasurys will outperform the short end. So forward guidance gives a green light to all long duration plays.
  • Gains from longer duration is not going to be enough to make up for the loss in yield for diversified portfolios. Therefore, as the curve flattens private portfolio prefernces will shift out the risk and yield curve. A flatter yield curve favours high yield, leveraged loans, emerging markets, convertible bonds, and equities.
  • Bond-heavy pension funds in particular will be affected by a flattening of the yield curve and will increasingly chase yield.
  • The ECB can compete with the Fed on forward guidance but it cannot compete with the Fed on QE. Therefore, the shift to forward guidance will make the ECB seem increasingly dovish on a relative basis and may help keep the Euro from appreciating. Note, however, that the Fed’s economists are talking about relaxing the inflation target while there is no such talk in Europe despite the threat of deflation.
  • Bank net interest margins will continue to shrink. As a result, banks will continue to rely on non-interest income and lower charge-offs to boost earnings. Eventually, however, credit quality will diminish as banks chase yield.

I see the Fed’s new regime as medium-term bullish for asset prices but long-term bearish. I believe that yield- and risk- chasing behaviour will lift asset prices over the medium term but will also cause a misallocation of resources which leads to a large downside risk in high beta assets when the cycle turns down. At this juncture, it seems that the Fed is not ready to explicitly lean against bubbles. That should give a green light for risk seeking until the Fed nears its economic targets for hiking rates, at which point the risk will be for a violent crash in asset prices.

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