In January 2016, I wrote about some interesting but little-heard-of research by Dr Leo Krippner at the Reserve Bank of New Zealand on the subject of quantitative easing. It was therefore nice to see that he had received a Central Banking Award for Economics last year in relation to this work.
"Monetary policy in the US has only just stopped being accommodative"
I had trouble understanding the detail of Krippner’s research myself but, to put it as simply as possible, he used bond option pricing techniques to represent quantitative easing (QE) in terms of an effective central bank policy rate, his so-called ‘shadow short rate’ (SSR). QE is required when interest rates hit the zero lower bound (ZLB) since negative rates would result in a flight from bank deposits into better (zero) yielding physical currency.
The QE that followed the Great Financial Crisis (GFC) was simply what was required to loosen monetary policy even further, given that the zero interest rate was still too tight. This essentially represented a shift from setting the price of money (interest rates) to setting the quantity of money (QE). Looked at in this way, it makes sense that QE can be represented as a hypothetical (negative) policy rate that would be in place if physical currency did not exist and thus there was no need for QE.
Chart 1 plots the dot plots (I never thought I would ever write those words!) of the Fed’s expected future path of the Fed Funds rate, Krippner’s SSR, as well as the actual Fed Funds rate and a prediction (mine) of its future path.
There are a number of things to note:
When the Fed Funds rate is above zero, the SSR tracks it very closely. In other words, the model works when rates are above the ZLB.
QE was at its most stimulative in 2012, with the SSR at an extraordinarily low -4.3% (in fact the daily low came in 2013 but the annual average low was 2012).
The Fed’s dot plots have been hopeless so far – that the first dot plots in February 2012 suggested the Fed Funds rate in 2015 would be 4.2% is positively fantastical!
The most recent dot plots from the July report suggest that the Fed Funds rate will peak at 3.3% in 2020, implying another four 25bps hikes until then.
There is no science behind my prediction of the Fed Funds rate in the chart – it is simply an extrapolation that appears to fit the dot plot data. Nevertheless, it is also consistent with my belief that we will see an economic downturn in 2021 (the pace at which it is reduced seems to be consistent with that seen during the GFC). Clearly, the Fed’s dot plots are not predicting a downturn but then it is not the Fed’s job to predict recessions but to prevent them.
It is also instructive that on the basis of my extrapolation, this cycle will see trough to peak in the Fed Funds rate, based on the SSR, of around 8 percentage points (peak of 3.5% in 2020 minus low of -4.3% in 2012). This is very high in historical terms. Indeed, even using the current 2.20% Fed Funds rate, the percentage point increase thus far has been very large.
By the way, if you thought that a -4.3% SSR in the US was low, take a look at Chart 2 which shows rates elsewhere in the world. First, it should be noted that the -4.3% was an annual average; the daily low in fact came on 3 May 2013, at -5.5%. Moreover, if you thought that was low, look at Japan. Although it is now rising, its SSR hit -8.7% in July of this year.
I recently suggested that the market falls seen in October were not the start of a bear market relating to a recession that had started to come into view. That was because yield curves at that time were still positive, suggesting a recession was still over the horizon.
However, with the recent fall in the US 10 year below 3%, and the likelihood of a Fed hike this month, it is possible the 10y/2y curve will invert sooner than I thought would be the case. This would increase the probability that October represented the start of the bear market, not a correction. That said, I still think the next recession is some way off. After all, monetary policy in the US has only just stopped being accommodative, while in other major economies it is still very loose - the average SSR across the four jurisdictions has only just risen above -2% (see chart 2 below).
Of course, I could be wrong, which is why we started preparing for the next bear market some time ago. At the risk of sounding like a broken record, it is best to brake ahead of rather than at the bend. There you go - two metaphors for the price of one. Happy Christmas!
Published in Investment Letter, December 2018
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.