Making sense of the FED U-turn
The Federal Reserve, in the latest Federal Open Market Committee (FOMC) meeting, decided to leave the target range for the federal funds rate unchanged at 2.25%-2.5% and hold off any future hikes until new information necessitated a need for change. This was interpreted as a major reversal on the future predicted path of the target range, since the Fed in previous meetings had signaled gradual increments in the coming periods, consistent with the trend it has followed since 2015, and had even remarked that the current rates were a long way short from neutral. In addition to that, the Fed expressed its intention to adopt a more flexible approach with respect to balance sheet normalization and to not let it continue to run on ‘auto-pilot’. This essentially meant that the Fed would not let its balance sheet, which had swelled from $860 billion to $4.5 trillion as a result of post crisis quantitative easing, shrink by $50 million per month automatically (this practice started in late 2017), but instead would resort to altering both its composition and size, if and when it realizes the need to.
Both above stated measures implied a more cautious and unpredictable monetary policy which would give more weight to incoming data on the economy and markets than past models. Apart from the statements at the FOMC meeting, the Fed released a series of dovish statements at various conferences and events throughout last December, which had a big impact on the reversal in the downturn in stock and credit markets we witnessed in the last few weeks. The Fed’s hawkish statements in October led the market to price in three hikes of 25 basis points each in the target range in 2019, causing significant upheaval in the markets in terms of value and volatility. After its latest statements, however, the markets are pricing in no rate hikes and signaling positive probability to rate cuts, thus marking a significant turnaround from hawkish to dovish in the Fed’s stance.
In the following paragraphs, we try to understand the economic and financial factors that may have been responsible for the above stated actions taken by the Fed.
We first consider the inflation and full employment objective of the central bank. The Fed has repeatedly failed to reach its inflation target of 2% in the post crisis era. This has happened despite the unemployment rate hovering around 4% in last couple of years, much below the historical natural rate of unemployment (around 5%). A Philips curve reasoning implies that low employment leads to upward pressure on wages, thus leading to price inflation. Evidently, this pressure on wages has yet to materialize in the current cycle, even in the face of creation of a great number of jobs.
I provide two possible explanations for this anomaly.
1. Labor force participation rate has risen consistently in the last couple of years, particularly for women aged 25-34, and is yet to reach pre-crisis levels overall.
2. The structure of the labor market has undergone a sea change with increased technological levels and the ‘amazonification’ of labor market giving rise to the gig economy, which has allowed workers to take up an increasing number of part time jobs at compressed wages.
The two factors explain how so many jobs created in the previous few years was absorbed by the labor pool without having a significant impact on wages.
In light of these dis-inflationary factors, the US economy entering the end of its business cycle, the tax-cut effects subsiding, earnings forecast for major companies being subjected to reductions compared to previous years, heightened trade uncertainty with regard to China and recessionary signals coming from Europe (particularly from Italy and Germany) it is reasonable to assume that downside risks to the economy have increased, thus meriting a more dovish approach from the Fed.
As mentioned above, one of the key decisions of the Fed, apart from the change in stance with respect to the fed funds rate, was to halt the automatic reduction of its balance sheet. The Fed had, in the years subsequent to the crises, increased its balance sheet by buying unprecedented amounts of treasury and asset backed securities. While, this was initiated to provide much needed liquidity to financial markets in the wake of the crises, its extended use, created a re-balancing effect which reduced yields to very low levels on safe assets, thus, bolstering the demand for risky assets and propping up risk appetite. This was followed by record issuance of high yield bond (BBB) and leveraged loans. Hence, massive amounts of easy credit were provided to highly leveraged entities with limited cash flows.
The announcement in October about balance sheet reduction (quantitative tightening) apart from causing a downfall in stock indices also led to a widening in credit spread between high and low rated bonds and poor performance by leveraged loans. This was expected, since a quantitative tightening would, naturally, lead to the opposite of the kind of portfolio re-balancing that we earlier had within the Quantitative Easing era. It would, thus, lead to diminished risk appetite and investor demand for risky securities.
More significantly, if the whole process were to take place in an environment of declining earnings and a slowing economy with highly leveraged companies struggling to generate adequate cash flows, it is highly likely that we would see a series of defaults and sell offs on the securities issued by them, thus, causing huge losses of value for investors. Notwithstanding, the impact of low earnings on economic output, such a big loss in wealth of retail investors and pension funds (since they have significant exposure to this asset class) could shatter confidence in the economy and send it into a recession even if a full-blown crisis is avoided due to low exposure of banks to these securities. This makes the Fed more averse to financial tightening currently than ever before, since a fall in the risk appetite, which was propped up by QE, could have such drastic effects in a slowing economy.Therefore, apart from keeping the economy running smoothly, FED now also has an added objective of not letting risk appetite slide significantly in times of distress.Therefore, in the latest FOMC meeting, FED deemed it prudent to call off interest rate hikes and automatic balance sheet reduction, as it saw downside risks to the economy increase and not enough buildup of inflationary pressures, both of which would not warrant souring of the risk appetite due to additional tightening. This also makes it more likely, in the case of overheating of the economy and higher inflation in the future, that the Fed will only use one of the above-mentioned tools to stabilize the economy.
WRITTEN BY ADITYA VAGHELA FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT