In June 2017, former Federal Reserve Chair Janet Yellen mused that quantitative tightening in terms of balance sheet normalisation would be like “watching paint dry”.
Yet, while the paint was drying, the Fed was at panic stations in January this year, after the stock markets’ cardiac arrest in 2018Q4 was blamed on its rising rates and shrinking balance sheet.
The Fed duly blinked and slammed on the brakes – barely less than a month after Chairman Jerome Powell had triumphantly announced that quantitative tightening “was on auto-pilot”.
To compound the confusion, the President of the Federal Reserve Bank of San Francisco has since confirmed that policy makers see interest rates as a primary tool and the balance sheet as a secondary tool of monetary policy. Translation: Quantitative easing will no longer be purely an emergency measure but is now part of the Fed’s toolkit.
The old joke that anyone who is not confused doesn’t really understand the situation applies to central banks today. After averting a 1929-style global depression in the wake of the Lehman collapse, central banks have faced a Herculean task to unwind their emergency measures. It’s been a journey into the unknown.
“The Fed’s rate cycle increase is over and its next move will be a cut”, the Wall Street Journal stated on May 9th. It expected the Fed fund rate to stay within its 2.25-2.5% range till the end of 2021.
The question is what will happen when we enter the next recession when rates will still be very low. This would mean more quantitative easing. Interest rates could conceivably be pushed into negative territory in ever more countries. For now, quantitative tightening has been dogged by two worries.
First, financial markets have become addicted to QE. What was seen crisis-era medicine has turned into a drug. They are not alone. Even the real economy can’t seem to kick the habit. In the US, it now takes 4–5 dollars of monetary stimulus for every one dollar increase in GDP, compared with 1–2 dollars thirty years ago.
Second, the near-zero rates have stimulated another debt binge: companies have raised billions in bonds, mortgages have been taken out, and governments are nursing vast budget deficits. With rising rates, it would be near-impossible to service the debt without creating a wave of bankruptcies. Defaults on consumer debts have already been rising in all metropolitan areas of the US.
QE now sounds like a Faustian bargain: once you’ve made your deal with the devil, there is no way out. More immediately, it begs two questions.
First, is the old-style investment cycle redundant – maybe not forever, but at least for the next few years?
Second, since interest rates are an unrewarded risk, should pension investors hedge them before they head south again and balloon the plan liabilities?
I would be very grateful to hear your views. I have described the dilemma that pension investors face in my monthly piece in today’s FTfm (13th May 2019). If you are a digital subscriber, the link is here.