In his latest Ahead of the curve, Neil Williams, Group Chief Economist at Hermes Investment Management, sets out the implications of the US Fed becoming the first central bank to suggest it’s worrying about our addiction to QE. By starting to wind down its $4.5trn stock of assets accumulated by QE, it’s about to become the test case for how to push both levers: gradual interest-rate hikes and balance-sheet reduction.
By starting QT, the Fed will take some of the heavy lifting away from rate rises…
With the Fed believing it’s the QE stock that matters, it’s sending a subtle signal that will allow it to tighten by doing nothing – that is, by no longer reinvesting the proceeds of their maturing bonds. With this in mind, the Federal Open Market Committee (FOMC) are proposing to start phasing out US Treasury and MBS reinvestments “relatively soon”.
To quantify the impact on rates and gauge how policy should shift, we have updated our ‘Policy Looseness Analysis’. By including QE, QT, and fiscal considerations, our analysis beefs up the Fed’s Taylor Rule which currently recommends an unrealistically high and potentially damaging peak policy rate of about 4.75% (close to its long-term average). At 350bp over the Fed’s current 1.00-1.25% range, those FOMC members targeting an unusually low peak rate are, helpfully, ignoring their own Rule.
By contrast, our analysis suggests the following...
First, by sustaining the Fed’s newly proposed ‘non re-investment’ (QT) programme, the Fed could ‘take out’ or preclude as much as 130bp of further rate hikes by 2019.
As a guide, our two charts below are based on: the Fed starting QT this October at their proposed $10bn per month, gradually rising to, and, then being maintained at, a $50bn per-month pace after a review (chart 1); the Fed staff’s assertion in 2011 that $600bn of QE would have the equivalent effect to slicing an extra 75bp off the Fed funds target; and there is symmetry for QT.
Second, however, unless the Fed’s new QT programme is later accelerated, it would take till 2023 before the balance sheet is taken back to the $1trn considered ‘normal’.
This gives credence to the ‘new normal’ view of low-for-longer rates & yields…
And, third, US interest-rate normalisation will also be slow. On the basis of our analysis, even a possible $1.1trn QT by 2019, which seems likely, would leave the de facto, QT-adjusted, real funds rate negative. Furthermore, this is the case on both our (chart 2) relatively dovish and the FOMC’s hawkish interest-rate views.
What this does is give credence to the ‘new normal’ view of low-for-longer global rates and bond yields - rather than a swift ‘normalisation’ in coming years back to pre-crisis levels. Otherwise, the US’s eight-year expansion - currently the third longest in its history - may not, in summer 2019, have the accolade of becoming its longest ever.