Murphy’s Law says that what can wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” In Captain Murphy's Diary I comb the financial markets for risks that are lurking out there, preparing to pounce.
The risk that I consider this month is the risk of growth in the US slowing significantly as a result of the ending of QE3. Although all the talk is of interest rates rising, it is possible that the tapering of asset purchases by the Federal Reserve that began in January 2014 constituted a significant tightening of monetary conditions, the impact of which is yet to be felt.
When interest rates hit the zero bound, central banks have only one option if they want to loosen policy further: QE. But can one measure the impact of QE in terms an equivalent level of short term interest rate? The answer is ‘yes.’ In a paper entitled “A model for interest rates near the zero bound,” Leo Krippner of the Reserve Bank of New Zealand lays out a method for converting central bank asset purchases into an effective short-term interest rate, what he calls the “shadow rate”. The maths is complex but to put it as simply as possible, Krippner uses bond option pricing techniques to determine what the short term interest rate would be if physical currency did not exist (central banks cannot in reality lower interest rates below zero because people would instead hold physical currency).
The chart below shows the actual Fed Funds rate versus Krippner ’s shadow rate. It is interesting to note that since 2012 the shadow rate has increased by nearly 5 percentage points. This is similar in size to the increase in the actual Fed Funds rate between 2003 and 2006, arguably the cause of the fall in property prices that precipitated the global financial crisis.
While it is by no means clear that the impact of a 1 percentage point rise in the shadow rate is equivalent to the impact of a 1 percentage point rise in the actual rate, one would be wise to note that interest rate increases tend to impact economic growth with a considerable time lag. Knowing about Krippner’s work should help keep one more wary about the outlook for growth and perhaps to better interpret any unexpected weakness.
Published in Investment Letter, August 2015
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.