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Tightening by doing nothing...

In his May issue of Ahead of the Curve, Neil Williams, Group Chief Economist at Hermes Investment Management, discusses his view that while markets are still taking a ‘glass-half-full view’ of the world, protectionism is the new risk emerging. This he argues, suggests we face a year of two halves – where stimulus-euphoria gradually gives way to stagflation concern. Helpfully, though, the trade-off is that central bank policy rates stay lower than many expect.

Amid this, the US Federal Reserve remains the test case for whether central banks can ever ‘normalise’ policy interest rates. We expect it to try, but fail – peaking out at a far lower policy rate (1¼-1½%) than in past US recoveries.

Adjusting for QE, nominal US & UK policy rates could be as low as -4¼% & -3%...

We update our ‘Policy Looseness Analysis’ to gauge how the US and UK’s overall – monetary and fiscal – policy positions should shift into 2018. By taking explicit account of QE, true US & UK policy rates may be as low as -4¼% & -3% respectively. This is far lower, of course, than their maximum official rates (unadjusted for QE) of 1% and 0.25%.

Running true rates this low would make the FOMC increasingly uncomfortable if at the same time the QE stock remains as bloated as it is (see chart below). Some FOMC members believe that persistent excess capacity warrants a much lower ‘neutral’ (or ‘Goldilocks’) policy rate than in previous recoveries.

Therefore, to do some of the ‘heavy lifting’ and help achieve a low peak rate, the Fed could in tandem push on the other monetary lever: quantitative tightening (QT). Admittedly, after eight years of running QE, the challenge will be to ultimately sell back some of the assets without higher long yields triggering a sharp rise in US mortgage rates.

However, with the Fed and BoE believing it’s the QE stock, rather than flow, that matters most, a less visible tightening signal than raising rates aggressively might be to allow the stock to erode naturally, by no longer reinvesting the proceeds of their maturing bonds. To avoid sharply higher yields, of course, even this may require ‘forward guidance’.

The easiest way to normalise monetary policy is surely to tighten by doing nothing…

Selling the assets back is admittedly one for later, and would need to be done gradually to minimise the disruption to bond markets. CHART

Nevertheless, as a precursor, terminating the reinvestm ent programme would surely be the gentlest way of tightening – in effect by ‘doing nothing’.

It would help keep peak rates low, and give comfort that central banks are not falling ‘behind the curve’. It may even go some way to reducing the downside of QE – evidenced by asset-price distortions, suppressed saving, and funding strains on many pension schemes.

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