Today’s Commentary
Summary: I believe policy makers at the the Federal Reserve have soured on the marginal effectiveness of quantitative easing as a primary tool for monetary policy. As interest rate policy is still not effective with the policy rate at zero, forward guidance will take on a more central role as the Fed tries to bring interest rate policy back to the fore. If sucessful, the Fed will begin to assert more dominant control over long-term interest rates.
Historical narrative
When the financial crisis hit in earnest in 2007, the Federal Reserve began slashing the Fed Funds rate drastically. The Fed took the rate from 5.25% in August 2007 to 0% in December 2008, a reduction of 5.25% in 16 months. This was an unprecedented level of monetary easing. Yet, the economy was still in freefall. Thus, the Fed felt (reluctantly) forced to turn to unconventional monetary policy tools.
The first weapon the Fed turned to as an unconventional monetary policy tool was quantitative easing. I have highlighted how the conventional use of monetary easing diverges from its inventor’s Richard Werner’s policy prescription. Nevertheless, the Fed’s QE1 program was not designed to boost the economy so much as it was designed to intermediate in dislocated markets. Banks refused to fully execute with each other on their primary function as financial intermediaries out of fear that bank counterparties were insolvent. Thus, the Fed felt forced into taking the other side of transactions with financial institutions that other financial institutions would normally have taken. This swelled the Fed’s balance sheet with assets of a questionable nature and made the Fed a lightning rod of criticism.
Eventually, the market dislocations began to ease and the Federal Reserve stepped back from its intermediary function. QE1 ended. However, the economy was fragile and when recession loomed again, the Fed turned back to its policy tool kit and began QE yet again, this time to support economic activity, by buying up Treasury bonds. Yet again, the Fed’s unconventional policy actions with QE caused the Fed to take on heavy criticism, especially because the U.S. federal government was running large deficits and QE was seen as facilitating these deficits.
I believe the Fed turned to forward guidance as a policy tool in 2011, largely to deflect this kind of criticism. In June, I asked what are the differences between QE1, QE2 and QE3? and predicted that “it is unlikely that the Fed will go back to the well for the same policy since QE2 has proved ineffective.” My view was that, “the Fed would essentially guarantee a rate and let the markets move interest rates to that level. Of course, the Fed would promise to defend the rate(s) if and when necessary. The Fed may be tested initially, but punters would lose their shirts fighting a market player with a potentially unlimited supply of liquidity. So I would expect the balance sheet effects for the Fed to be muted. And clearly, if QE3 reduced rates in addition to having largely the same impact as QE2 as well, it would be a more powerful tool.
There could be internal dissent to such an aggressive policy. I do not expect QE3 now nor do I expect it unless the economy deteriorates further. So the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Look for how the Fed reinforces its commitment to “exceptional low levels for the federal funds rate for an extended period”. If Bernanke is forceful about this commitment in this week’s FOMC press conference, people will be forced to accept the likelihood of permanent zero and the term structure will flatten further and further out the curve.”
This is exactly what happened.
Reducing net interest margins and reaching for yield
Here’s the first problem: Permanent Zero is toxic and leads to depression.
Zero rates depress interest income in the private sector, depleting savers of expected income and forcing them to reach for yield. In addition, pension funds that have specific return targets in order to pay off future pension liabilities, are forced to either paper over the problem through opaque accounting as state and local governments have done, top up funds out of operating income, reach for yield, or take on risk. There are no other options when nominal returns fall due to the fall in nominal interest rates.
Zero rates also depress net interest margins at banks. I first told you this would be problematic in 2010 and since that time, we have indeed seen bank net interest margins shrink dramatically, to the point where all incremental income is derived from non-interest income fuelled gains or from accounting gains from lower loan loss provisions. For example, in June, the FDIC reported that banks it regulates in the U.S had record aggregate accounting gains in the previous quarter. But it noted in the first paragraph that “Increased noninterest income, lower noninterest expenses, and reduced provisions for loan losses accounted for the increase in earnings from a year ago”. What this means is that banks have been getting a depreciating percentage of incremental income from the core lending activities which serve public purpose and justify access to lender of last resort liquidity. Instead, banks have turned to more speculative activities and reduced provisions for future loan losses and reduced corporate loan credit quality so much that the Fed has warned on the lax lending standards.
These are the kinds of risks that lead to asset bubbles, resource misallocation, excessive levels of private debt, and, thus, to crisis.
As the risks have grown that the Fed’s monetary easing is creating a distortion in markets which can be destabilizing, some Fed governors have begun to openly worry about how to reduce policy accommodation. Fed Governor Jeremy Stein wrote a paper which began the public debate on this issue. But other top Fed officials have voiced concerns including Fed Chair-nominee Janet Yellen. In fact, Yellen was one of the first Fed officials to voice concerns about overly accommodative monetary policy, stating that “it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage”. She has portrayed the risk for bubbles from excess accommodation as a trade-off with the Fed’s desire to fulfill its dual mandate of supporting employment and price stability. Earlier this year, she said continued accommodation is warranted because inflation is not a threat, unemployment remains elevated and she does not “see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.”
Clearly, her view of the situation is widely shared at the Fed because the Fed has yet to taper its pace of large scale asset purchases (LSAP). And with the recent political dysfunction on display over Obamacare and the debt ceiling, the accommodative view that Yellen has championed is even more likely to win converts. She hopes, then, that the risks of accommodation are not hidden from policy makers right now, only to eventually manifest themselves during the next recession – something I believe is happening.
Fed miscommunication and QE versus forward guidance
Despite the first move in 2011 to forward guidance as a policy tool, the Fed embarked on a fourth round of monetary easing and a third round of quantitative easing last year. This time, the Fed focused on mortgage assets as well as Treasurys because it wanted to have a more direct impact on risk premia in that market because housing has been central to the sluggish growth coming from deleveraging due to mortgage-related household debt. Thus, the Fed now had two unconventional policy tools in place at the same time: forward guidance and quantitative easing.
Sometime early this year, policy makers began to sour on QE as the most effective policy tool to use to communicate Fed monetary policy. It’s not clear to me when or why this shift began but the shift was clearly evident in Chairman Bernanke’s comments in February when he referenced risks from accommodation and waved them aside. Jeremy Stein had just made his now famous speech about the risks from reaching for yield and Bernanke felt he had to defend policy accommodation.
For me, that was when QE began to recede as a policy tool and forward guidance started to take on a bigger role. Soon thereafter, Bernanke inexplicably began to talk about tapering QE, something that caused the market to go haywire as yields backed up. The Fed wants to normalize policy as soon as is practicable within the confines of its dual mandate to support employment and price stability. That means Bernanke’s tapering comments were a manifestation of the Fed’s looking for any reason to move away from QE and other unconventional policy tools and toward interest rate policy as the primary tool. This is why QE is out and forward guidance is in. Last month, I outlined how the Fed would use forward guidance as the bridge tool toward policy normalization and this is why tapering has to happen.
Here’s the problem.: the Fed has botched the job and made a hash out of its communication of future policy. Bernanke was telling us that forward guidance is “stronger and more reliable” than QE. Yet, the Fed has failed to use forward guidance in anything resembling a systematic way. It has been just the opposite, with the Fed actively undercutting its credibility by moving the goalposts on its policy targets and triggers. Tim Duy’s criticism here has been especially good.
The Yellen Fed
I believe this period of chaos on the communications front is over. Janet Yellen is known to be someone who likes a rules-based approach and who is willing to stick to those rules. That means her current dovish policy stance is only based on that stance being appropriate given the macroeconomic conditions.
Last month I wrote the following:
” As the Fed moves toward the interest rate policy tool it has become more specific about forward guidance:
- The Fed started by saying it would keep rates low for a considerable period
- Then the Fed made general and unconditional macro-based threshold commitments
- Then the Fed began making specific and targeted macro-based thresholds and triggers on unemployment and inflation
- I believe what is coming next is also more on a lower bound inflation threshold in order to be able to revert back into the QE paradigm if the economy undershoots
While the Fed is still in the QE paradigm, it will continue to show us the following:
- The Fed will send signals to the market on its level of accommodation by adding to or reducing duration from the market”
Under Yellen the Fed will strictly adhere to the specific and targeted macro-based thresholds it makes on employment and inflation, meaning that we are likely to see a greater set of rules develop instead of reliance on one rule or target like the 6.5% unemployment threshold. The Fed can then use the labor participation rate or mortgage rates as signals in addition to the 6.5% threshold to communicate to the market.
The key here is the rule i.e. how credible the Fed is in its statements because of the time inconsistency that a rules-based approach creates. Everyone in the market knows the Fed has an incentive to set a target and then undercut that target if over time things do not proceed as planned. And so, players will front-run the Fed because of this. The Fed can increase the power of its rate easing approach only if it is credible. And that means making targets that monetary policy can actually influence enough in the short-to medium- term that the Fed is not forced to backtrack. I believe Yellen understands this and expect a more focused communications strategy as a result. Jeremy Stein, who is concerned about bubbles, is also in favour of this rules-based approach.
A credible rules-based approach will mean more Fed control over interest rates. And because I believe the Fed will maintain a zero rate policy for longer than anticipated, it may mean lower long-term interest rates in the U.S.
One last thought here: Credible lenders of last resort use price, not quantity signals. What the Fed wants is to increase its influence over the economy despite the zero lower bound by extending its influence over interest rates beyond Treasurys and beyond the short-end of the curve. It can only do this by targeting non-policy interest rates for its communication strategy. Targeting quantity as in quantitative easing is a uniquely unsuited way of doing so. We should welcome the end of QE as the Fed’s primary policy tool.