Spiraling Down The Rabbit Hole: What Happens When The Ammo Is Gone?

Listen, there are people out there who are concerned about central banks not normalizing in time for the next downturn.

We’ve discussed this on too many occasions to count, perhaps most cogently (because to be sure, everything published in these pages isn’t cogent), in “I’m Out Of Bullets, How About You?”

In a recent note, BNP takes up the issue, discussing where things stand for the Fed, the ECB and the BoJ vis-a-vis the normalization debate or, more simply, with respect to whether the big 3 central banks are running the risk of missing their window.

Below, we’ll briefly outline the predicament for each bank, followed by excerpts from BNP’s take.

Although folks have been having the “ammo” debate for years, it’s been thrown into stark relief over the past two weeks as Mario Draghi and the ECB have been forced to acknowledge a deceleration in the eurozone economy just as they dropped the dovish language on APP from the policy statement (in March).

At the post-meeting presser for the April meeting (last Thursday), Draghi was careful to downplay the recent soft patch, suggesting it was likely transitory. And he’d better hope that turns out to be some semblance of an accurate assessment, because with the ECB still mired in NIRP and with APP still running at a pace of €30 billion a month, they haven’t even begun to replenish the proverbial ammo. The possibility that the euro will gain some traction as a safe haven only adds to the risk – currency strength undercuts growth and imperils the inflation target and if the next global downturn emanates from the U.S., it’s entirely possible that the euro could appreciate, making it even more difficult for the ECB to engineer growth and inflation.

Here’s BNP:

Let’s turn to the eurozone and the challenges it may face if a recession hits, where we assume this is US-led. Global trade growth would of course suffer, which would hit the open eurozone economy hard, leading to lower investment and employment. The first reaction in the last downturn from eurozone policymakers was to assert that the US problem would not affect Europe much. Hopefully they have learned and will move more quickly than last time. But what can they do? Core inflation is only 1% in the eurozone and while we forecast a rise to 1.6% by end-year, inflation expectations seem less stable in the eurozone than the US. We might see inflation fall more quickly than the US in a downturn. The current deposit rate is -40bp and looks unlikely to reach zero, in our view, until the end of 2019 at the earliest. This would leave the ECB with very little rate ammunition to stabilize the economy.

The problem could become more severe if the euro were to appreciate on the foreign exchanges. While the dollar might rise in a risk-off scenario against emerging market currencies and commodity exporters, there is a good chance that the JPY, CHF and EUR would be seen as “safe havens”, at least to start with. Given the large outflows from the eurozone in recent years and the tendency for funds to flock home in a crisis, the EUR could appreciate, hitting activity and dampening inflation. A return to negative rates would be likely in our view, though will -40bp be a deep enough cut? We doubt it.

This is because the last two cycles have seen a eurozone output gap of 2-2½% of GDP open up, according to the IMF. A repeat from current levels (where the output gap is close to zero) would require cuts in rates of 1% to 1¼%, according to the Taylor rule. Moreover, if experience of the great recession and the euro crisis is a guide then core inflation might fall by 1% or so, requiring, according to the Taylor rule, cuts of another 150bp. Thus a recession could require rates to be cut to -250bp. This hardly looks feasible.

A return to QE would look all but inevitable, though for several countries ECB holdings of bonds are close to the 30% limit the ECB has set itself. There is a high probability this limit would be lifted — maybe as far as 50%. Along the way, legal challenges to the ECB breaking the monetary financing rule would be likely, even more so if the 50% barrier were crossed. Purchases of other assets would come into question, as the ECB’s Mr CÅ“uré has suggested.

The BoJ is in a similar position, although with “Japanese characteristics” (to borrow Xi Jinping’s favorite phrase for describing anything and everything to do with Chinese policy). They’ve been desperately trying to assuage market concerns that Kuroda’s tacit admission re: pondering an exit from accommodation in the event inflation finally returns to target amounts to a signal that there is indeed a sell-by date on the BoJ’s policies. To be clear, there’s something absurd about the market’s overreaction to comments Kuroda made at his confirmation. After all, the whole purpose of accommodation is to bring inflation to target, so of course they would consider rolling back that accommodation in the event the target is hit.

But that’s how spoiled markets have become – traders can no longer accept that accommodation from the world’s most dovish central bank would ever be scaled back, even if that scaling back is tied to the achievement of the goals the accommodation was designed to hit in the first place.

This is complicated immeasurably by the yen’s traditional safe haven status and also by the fact that investors equate Abe with Abenomics (you know, because it’s named after him and all). The darker the political clouds over the PM, the more the market will be prone to anticipating a political shakeup and thus a more indeterminate future for Kuroda’s “very powerful easing”.

Thus the yen is prone to appreciating during risk-off episodes tied to exogenous shocks and prone to appreciating during periods of domestic political turmoil. Last week, the BoJ removed from the policy statement a mention of the projected time table for achieving their 2% target. Interpretations varied.

Here’s BNP:

Japan’s fiscal position is hardly solid, with the gross debt/GDP ratio likely to reach 234% in 2020 according to the IMF. However, a good deal of this is held by the Bank of Japan, so there may be room to increase the free float of debt. The problem with increasing the fiscal deficit by issuing bonds to the private sector could be higher rates. We see a good chance that “helicopter money” — a central bank financed fiscal expansion — might be instituted in Japan. Some would argue we have not been far from that in recent years anyway.

The pressure would be on the BoJ, probably through a stronger yen, to ease monetary policy further. But negative rates are hurting the financial system already and still lower rates would be worse. Printing money to finance fiscal expansion may well be the route taken.

For the Fed, things are a bit different. They are of course further along in terms of normalization, but they’re still a long way from having the type of policy “bazooka” they might need in a severe downturn, especially considering that implicit in their mandate is the maintenance of international financial stability.

Here’s BNP:

The Fed, we believe, will have scope to cut rates by about 250bp (we see a top for fed funds in this cycle of 2.50% to 2.75%). In the last two recessions rate cuts were 500bp and 550bp. So, it is likely there will be insufficient ammunition, even if it pushes peak rates beyond our forecast. The fact that there is little ammo could make the downturn worse, because economic and agents may quickly focus their attention on the worst case — getting stuck at the zero lower bound for a long time. Negative rates in these circumstances are a greater possibility than the Fed has so far been ready to acknowledge, with new Board member Goodfriend likely to be a proponent of negative rates. Could we go further than the ECB’s -40bp? Probably not without changes in the use of cash, which would seem politically unpopular and would also raise questions about the use of US dollars outside the US.

The Fed is probably reluctant to institute another round of QE, having made little progress in reducing its balance sheet so far. The Congress might object and the wider political implications could be unwelcome from seeming to prop up the stock market (the ‘Powell put’) and save the wealthy from their having bought overvalued stocks. QE might not come quickly, though we see a very good chance that it would come eventually if the economy looked like getting stuck with rates close to zero. But it did not create the inflation people hoped it would in 2008, so it may be less effective next time.

As you can see, we’re getting closer and closer to a scenario where things like deeply negative rates and outright (as opposed to tacit) helicopter money would become a reality.

That, in turn, gets back to the discussion from the “out of bullets” post linked here at the outset and also takes us back to the “spiral” discussion, whereby in an unanchored system, each bubble has to be large enough to subsume the last.

The vestiges of crises past always linger — creative destruction isn’t a viable option in the modern world. That means that by definition, future crises will be i) inextricably linked to their predecessors, and ii) more spectacular than those that came before. That second point (i.e. the idea that a defining feature of a fiat regime is a rolling boom-bust cycle that snowballs with each turn) means that policy responses will need to grow in magnitude over time to keep pace with ever larger busts.

Eventually, the busts become so large that the policy responses required to combat them become caricatures of themselves that border on absurdity.

That’s where we are now. Down the rabbit hole…