Previously, we forecast that the meeting of the world’s central bankers in Jackson Hole, Wyoming would be a non-event. We were on the mark except for one key outcome – the $A fell by over 1% after the US Federal Reserve (Fed) Chair Janet Yellen addressed the meeting. The gyration in the currency is captured in the chart below.
Figure 1. 1 week AUD/USD exchange rate
Source. Yahoo Finance
The $A moved through a 2% band in just a few hours as Australians slept on Saturday morning after Yellen’s speech. It had rallied before the address, but fell as newswires reported what she said.
We suspect that the RBA was wide awake early on Saturday morning and made some trading profits as the $A fell sharply. It would be good to know if their friends at the Fed had taken a trading position (long USD) before her speech. If so, we may ponder whether that would be insider trading? We can leave that one for the regulatory authorities to worry about..
But what did she say and was it comprehensible?
Yellen’s address was titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”. In general the speech was as bland as the title. However, there were a few notable comments, particularly her continued reference to a central bank “toolkit”.
Here we examine a few of the key statements to help us understand the policy settings of the Fed and the ramifications for Australia. In particular, we will try to see what is in the tool box!
The best place to start is with the speech’s conclusion.
“Although fiscal policies and structural reforms can play an important role in strengthening the U.S. economy, my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.”
So there you have it. The US and indeed the world will always need central bankers and their bag of policy tools. Importantly, some policy tools have not even been invented as yet. These tools would appear to be under development in economic laboratories. While they may be released (for discussion purposes) in an unproven form, they will only be utilised after much further research and debate.
All of us should hope the economic boffins know what they are doing and don’t release economic drugs that are addictive – like the ones that have flowed out of the “Japanese toolkit” for the last 15 or so years.
What might these new monetary tools look like? There were no hints or insights presented in the Yellen speech – maybe they will be subject to patent protection at some point! However the spectre of sustained lower interest rates was clear throughout the address. This suggests that investor pain stemming from high asset prices and low yields will be a feature of investment markets for a while yet. Central banks have taken us to this point and foresee the future as more of the same!
Figure 2. The Three Central Bankers
This is particularly important for Australian pension investors to understand. Further, the Australian Government needs to take note as it attempts to restructure our superannuation system and tax regime. The superannuation system needs to be structured along lines of fairness while ensuring the economic and social system is not undermined by excessive tax breaks. The Government, acknowledging the low interest rate cycle, needs to declare what the maximum size of a single person pension fund (with tax benefits) should be, based on a reasonable expectation of returns. With bond yields and cash rates holding well below 2% across the world, the capital base of a single pension fund will need to be larger than $1.6 million.
Some gems from Yellen’s speech – and our interpretation of what she said
“The Global Financial Crisis and Great Recession posed daunting new challenges for central banks around the world and spurred innovations in the design, implementation, and communication of monetary policy.”
Our interpretation – Monetary Policy is managed like the refurbishment of a house before sale. The process requires continuous marketing with more words than actions. The marketing process was expanded during and after the GFC. Central banks found that forward guidance – that is, telling the market what we are thinking of doing in advance – becomes important so that big institutions (mainly commercial and investment banks) would not lose more capital trading markets.
Figure 3. Fed lady sings
“As noted in the minutes of last month’s Fed meeting, we are studying many issues related to policy implementation, research which ultimately will inform the Fed’s views on how to most effectively conduct monetary policy in the years ahead.”
The Fed’s economic scientists are continually testing and reviewing current monetary policies in test tubes in an effort to understand why they haven’t worked as previously thought. When they work this out, we will have a chance of developing some new tools that work. We will keep you posted of any breakthroughs.
“…one lesson from the crisis is that our pre-crisis toolkit was inadequate to address the range of economic circumstances that we faced. Looking ahead, we will likely need to retain many of the monetary policy tools that were developed to promote recovery from the crisis.”
Believe me (Yellen) – both quantitative easing (QE) and zero interest rate settings were created by us (Fed) at the height of the GFC. While they may have been trialled elsewhere over the previous 60 years, and particularly in Japan, our adaption of them was completely new and revolutionary. While our economists cannot explain why they haven’t worked the way they did in the laboratory tests, rest assured we will use them again.
“Looking ahead, the Fed expects moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to 2 percent over the next few years. Based on this economic outlook, the Fed continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives. Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee’s outlook.”
Every economic indicator suggests that we (the Fed) will soon be lifting cash rates. While I have said this for the last two years, I don’t observe that the markets are listening. I say this because we anticipate that inflation will lift to about 2% in the next year even though all bond yields are well below this rate. Actually I have just realised that we do not believe what we are saying because the Fed is buying ten-year bonds at a yield of 1.5%!
“Prior to the financial crisis, the Federal Reserve’s monetary policy toolkit was simple but effective in the circumstances that then prevailed.”
Why did we ever experiment with these new policies? This new policy toolkit should be put back in the box and sent back to its Japanese manufacturers.
“The global financial crisis revealed two main shortcomings of this simple toolkit. The first was an inability to control the federal funds rate once reserves were no longer relatively scarce. Starting in late 2007, faced with acute financial market distress, the Federal Reserve created programs to keep credit flowing to households and businesses. The loans extended under those programs helped stabilize the financial system. But the additional reserves created by these programs, if left unchecked, would have pushed down the federal funds rate, driving it well below the FOMC’s target. To prevent such an outcome, the Federal Reserve took several steps to offset (or sterilize) the effect of its liquidity and credit operations on reserves. By the fall of 2008, however, the reserve effects of our liquidity and credit programs threatened to become too large to sterilize via asset sales and other existing tools. Without sufficient sterilization capacity, the quantity of reserves increased to a point that the Federal Reserve had difficulty maintaining effective control over the federal funds rate.”
The toolkit came with a money back guarantee. In fact, it should have come with a warning – if left turned on for too long, this toolkit will produce unlimited amounts of money that may cause unforseen problems. We left it on for too long and now cannot turn it off. But it’s not our fault!
“Of course, by the end of 2008… Faced with a steep rise in unemployment and declining inflation, the Fed lowered its target for the federal funds rate to near zero, a reduction of roughly 5 percentage points over the previous year and a half. Nonetheless, a variety of policy benchmarks would, at least in hindsight, have called for pushing the federal funds rate well below zero during the economic downturn. That doing so was impossible highlights the second serious limitation of our pre-crisis policy toolkit: its inability to generate substantially more accommodation than could be provided by a near-zero federal funds rate.”
We thought the European Central bank (ECB) was using the same Japanese toolkit. They clearly are not because they have negative interest rates. The instructions on our box say that the toolkit should not be used to drive interest rates into a negative position. We believe there must be an upgraded version (No.2) which the Europeans are using. We do however doubt that they tested the upgrade before using it.
Figure 4. Wise man
“What does the future hold for the Fed’s toolkit? …… As the Fed has noted in its recent statements, at some point after the process of raising the federal funds rate is well under way, we will cease or phase out reinvesting repayments of principal from our securities holdings. Once we stop reinvestment, it should take several years for our asset holdings – and the bank reserves used to finance them – to passively decline to a more normal level… Forecasts now show the federal funds rate settling at about 3 percent in the longer run.”
At this point, we haven’t yet worked out how to turn off the toolkit. Our laboratory tests have simulated “pulling the plug” but the results have been disturbing. Therefore we will continue to give forward guidance and suggest that a 3% cash rate is really only an aspirational target based on laboratory tests. While the 3% target is massively above current rates of just 0.5%, no one should worry. We believe the 3% level may take decades to achieve.
“Finally, the simulation analysis certainly overstates the Fed’s current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment. But that does not mean that the Federal Reserve would be unable to provide appreciable accommodation should the ongoing expansion falter in the near term. In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly – although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced… On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets.”
If the US happened to fall into a recession, then we will definitely upgrade to the Japanese toolkit “version 2”. This is a major upgrade from version 1, allowing the central bank to drive interest rates into negative territory. It also introduces a powerful QE upgrade that sanctions the purchases of mortgages, property securities, equities and dirty laundry. Hopefully this upgrade will not be necessary on my watch. If it is, I will quickly retire and move onto my lifetime public service pension.
Figure 5. Titanic