Heisenberg Report

The ‘Ammo’ Problem Is Back – And It’s Worse Than Ever

On Wednesday, Jerome Powell used his testimony before the House Financial Services committee to cement the case for a July rate cut.

Gone were references to “transitory” and “patient”. In their place: More than two-dozen mentions of “uncertainty”.

To be sure, the Fed has little choice in the matter. Disappointing market expectations risks tightening financial conditions, which, if the FCI shock were acute enough, would make a cut necessary anyway. The tail is wagging the dog, but c’est la vie.

When the Fed cuts, it will mark the culmination of a dramatic policy U-turn seven months in the making. The pivot started in earnest on January 4 when Powell, seated across from his predecessors at an event in Atlanta, seemingly learned how to communicate effectively with markets.

Of course, the FOMC’s global counterparts are along for the ride. The RBA has cut twice, the RBNZ has cut, the RBI has cut, Russia has cut, and the ECB rolled out a new round of TLTROs, enhanced its forward guidance and now appears to be on the verge of announcing a new easing package. The BoJ is just the BoJ – easing in perpetuity.

The decisive policy pivot has rekindled the “ammo” debate, especially as it relates to developed market central banks.

The worry with ultra-accommodative monetary policies (and especially experiments in NIRP) was always that rates wouldn’t be normalized in time for the next downturn. In the same vein, many fretted that if central banks were unable to unwind their balance sheets ahead of the next recession, there would be no way to argue that QE wasn’t tantamount to debt monetization.

“Central banks have always contended that QE is different from outright monetization because they (the central banks) were absolutely going to unwind QE as soon as practical”, SocGen’s Albert Edwards wrote back in February, adding that “his own view has always been that until QE is actually fully reversed, it is to all intents and purposes the equivalent of outright monetization, and so central banks are merely splitting hairs”.

Read more: Policy Failure, Ammo Shortages And The ‘Who Pays For It?’ Problem

Well, with the global economy now mired in a fairly deep manufacturing slump which threatens to spill over into the services sector and, eventually, into the labor market, and with trade tensions still on the boil, central banks are now being effectively forced back into the game having done little in the way of normalizing.

It’s true that when you measure things from the low in the shadow rate, the Fed has actually tightened more than previous cycles, but that doesn’t change the fact that we’re still uncomfortably close the lower bound in the US. Elsewhere, the situation is obviously much worse, as rates are negative across multiple locales. Where rates are positive, they’re either not that far from zero (e.g., in the UK and Canada) or else are on their way down (e.g., in Australia).

And so, we’re left to ponder how effective monetary policy will ultimately be at countering the downturn if things get worse. BofA is out with a rather somber assessment of that situation on Wednesday.

“This shock to global growth comes at an inopportune time [as] normally at this point in the business cycle policy makers would be building up ammunition for dealing with the next crisis”, the bank’s Ethan Harris writes, adding that were this a “normal” cycle, “policy rates would be normalizing so that there is plenty of room to cut in a recession, long-term bond yields would be even higher so that in a crunch unconventional policy could engineer an even bigger drop in bond yields, inflation would be headed higher, creating room to cut real interest rates significantly into negative territory should a recession appear and budget deficits would be low as the strong economy raises tax receipts and lowers income support costs”.

Almost none of that is the case this time around.

“The ECB and BoJ’s policy space problem was already serious before the uncertainty shock and now is considerably worse”, Harris laments, adding that “both central banks already have negative policy rates and worry that further cuts will hurt more than they help”.

On the Fed, Harris notes that late last year, BofA projected the funds rate would move up to 3.4% by 2020. Oh, how things have changed. Now, BofA sees the Fed cutting rates three times, down to 1.6%. That means that, to quote Harris, “relative to the old baseline, the Fed is now expected to use up half of its conventional policy ammunition in an attempt to offset the trade war shock and to ensure higher inflation”.

As far as QE and forward guidance go, the issue is that yields have already plunged so much that it isn’t clear how much lower they can go. The global stock of negative-yielding debt now sits above $13 trillion.


Increasingly, corporate bond yields across the pond are negative and, in a truly bizarre state of affairs, a handful of “high” yield bonds in Europe have gone negative of late.

“Forward guidance and QE work in large part by lowering bond yields and thereby encouraging investors to move into risky assets [but] bond yields continue to drop”, Harris writes, on the way to fretting that “in real terms, the loss of policy space is even greater”. For instance, he reminds you that “the BoJ’s goal is to overshoot its 2% inflation target, creating room for significantly-negative real policy rates” but BofA’s team sees inflation of just 0.4% this year and 0.7% next year and that’s “including an artificial boost from a third consumption tax increase”.

So, what’s the answer? Well, as usual, it may fall back on fiscal policy, but that’s hamstrung by political bickering and German mores. To wit, from BofA:

Despite high debt-to-GDP ratios, most of the major economies can expand fiscal policy without paying significantly higher interest rates. Indeed, with very low interest rates there is a tremendous opportunity to invest in infrastructure. Here the constraint is man-made. Countries in peripheral Europe are constrained by the Maastricht rules. Meanwhile Germany and other core countries are constrained by a cultural aversion to budget deficits and an understandable unwillingness to set policy based on the needs of the countries in the periphery. Japan seems obsessed with raising the consumption tax. The US is stuck in gridlock. Of the major economies, only China seems willing and able to test its fiscal limits.

This gets us right back to the appeal of populist economic policies in the west, both from the left and from the right.

On that note, I’ll leave you with a quote from the above-mentioned February note from the desk of Albert Edwards:

There has also been an increased flow of articles favourably disposed towards the controversial ideas of Modern Monetary Theory (essentially it is the idea that there is no government budget constraint when there is a sovereign central bank). I note that many of the more radical Democrats in the US seem to be adopting the idea and since I expect the US budget deficit to soar to 15% of GDP in the next recession, the ideas of MMT will surely become even more popular. I certainly think the Fed and other central banks will be desperate enough to adopt outright monetisation (aka helicopter money, that is to say the direct central bank financing of public sector deficits) in the next recession. And as that will coincide with public sector deficits in the mid teens, we will be conducting a live MMT experiment. Welcome to a brave new world!