In his latest Ahead of the Curve publication, Group Chief Economist Neil Williams, examines the effects of the unconventional monetary policy of the Federal Reserve and Bank of England, and whether central banks can ever ‘normalise’ rates.
Eight years on from the collapse of Lehman Brothers, and macro comparisons with 2008 can thankfully be diluted by the fact that US and UK real GDP are significantly up on their pre-crisis peaks, bank supervision looks tighter, and central banks, after a slow start, now have a proven track record of policy coordination.
Yet, policy rates in 2017 will stay close to the floor, while, separately, political risk in the developed economies - largely absent in 2008 - is building.
The US Fed remains the test case for whether central banks can ever ‘normalise’ rates. We expect it to try but fail - hiking the funds target just twice more, probably this December then in March or June 2017. But, with cold winds elsewhere, particularly in Brexit-tainted Europe, we expect it to peak at just 1% - way lower than its historic average of about 5%. We may thus face another two years of negative real rates, in the US and UK.
Adjusting for QE, true US & UK policy rates may be as low -4.5% & -2.5%
With this mind, we update our ‘Policy Looseness Analysis’ to gauge the extent to which G5 countries’ overall - monetary and fiscal - policy positions should shift in 2017. By taking explicit account of QE and fiscal positions, our analysis beefs up the ‘Taylor Rule’ the US Fed uses for setting policy rates.
The Taylor Rule (without QE and fiscal considerations) currently pitches the Fed’s target rate as high as 4.5%. This is 400bp above the Fed’s current 0.25-0.5% range, suggesting the Fed is underestimating just how accommodative the true rate is.
Charts 1 and 2 below summarise our results. For the US, we quantify the impact of QE on rates by adjusting real rates for former Fed chairman Bernanke’s assertion that the $600bn part of QE2 back in 2011 was equivalent to slicing an extra 75bp off the Fed funds target, which was at that stage just 0.25%. Extending this logic to the combined $4.5trn QE since 2009 infers about 550bp in total rate easing.
If we’re right about coming rate hikes, this suggests a de facto (QE-adjusted) nominal Fed funds rate of about -4.5% - much lower than the 0.5% ‘official’ rate. This equates to an even lower, -6% real rate when we factor in the Fed’s preferred core inflation target (core PCE).
Likewise for the UK, we have adjusted the policy rate for the BoE’s 2009 estimate that £200bn in QE was akin to taking around 150bp off the Bank rate. Extrapolating this, the cumulative QE since 2009 thus implies a UK policy rate of about -2.5% - much lower than the 0.25% official Bank rate. This suggests a real QE-adjusted rate (using CPI) as low as -3.25%.
In the long term, the Fed and BoE looking to peak out at lower than ‘normal’ rates can pull on the other monetary lever: ‘QT’ (quantitative tightening). This may go some way to removing the unintended consequences of QE currently evidenced by asset-price distortions, suppressed saving, and increased funding strains on many pension schemes. Otherwise, QE may be remembered more for these problems than the solution it offered in 2009 for unclogging the financial ‘plumbing’.
In the meantime, however, without convincing growth and employment recoveries, any contagion may, unlike 2008-09, be political rather than financial. Hopefully, governments in 2017 will help avert this by offering fiscal solutions - taking the policy ‘baton’ back from the central banks.