Underestimating The Biggest Risk Of All

I doubt Turkey’s Recep Tayyip Erdogan was aware of this when he compelled central bank governor Sahap Kavcioglu to cut rates at October’s policy meeting, but the (ill-advised) move marked a post-Lehman milestone.

“Turkey’s rate cut marked the 1,000th central bank rate cut since Lehman’s bankruptcy,” BofA’s Michael Hartnett wrote. “That’s one rate cut every three trading days since 2008.”

I’d be remiss not to note, up front, that citing a rate cut from Erdogan’s Turkey while musing about the post-Lehman monetary policy backdrop is a non sequitur. There’s no connection (none) between Erdogan’s quixotic, personal quest to triumph over interest rates (which he views as something akin to a living, breathing antagonist) and the rabbit hole of excessive monetary accommodation in the 21st century.

With that caveat out of the way, I’m free to proceed.

Hartnett included the obligatory layer cake chart (below) depicting more than $23 trillion of asset purchases between the world’s most important central banks.

The “liquidity supernova ends next year,” Hartnett said, flatly.

Maybe. But, as I’ll never tire of reiterating, policy normalization isn’t possible if by “normal” we mean pre-financial crisis. Incremental steps towards less accommodation are feasible, whether that means a partial taper of monthly bond-buying, a full taper with proceeds from maturing assets reinvested thereafter or a few rate hikes from a few developed market central banks.

But 2018 was instructive. Efforts to truly normalize policy, where that means central banks embark on a hiking cycle and allow their balance sheets to shrink, are destined to be rejected by markets.

Part of the problem lies in the effect of unconventional easing. You wouldn’t have known it by simply observing the absolute level of the policy rate nor by taking a quick look at the still-bloated size of the balance sheet, but measuring from the lows in the shadow rate, the degree of Fed tightening by the beginning of 2019 was 5.5% (figure below, from SocGen).

As SocGen’s Solomon Tadesse noted at the time, that was considerably “more elevated than recent cycles.”

Similarly, Deutsche Bank’s model suggested that between 2008 and 2015, every $1 trillion expansion of the Fed’s SOMA portfolio lowered the shadow rate by 62bps. WAM extension added an additional 29bps. “Put another way, the Fed had achieved the equivalent of a 25bps rate cut with every $400 billion of asset purchases or with every 10-month of maturity extension for SOMA during QE and Operation Twist,” the bank said, in February of 2019, a month after Jerome Powell’s famous “pivot.”

Often, policymakers emphasize that reducing the pace of bond-buying or raising rates by a relative handful of basis points still leaves policy “highly accommodative.” That may miss the point. Or it may be totally inaccurate.

Other assets are priced off risk-free rates and, more generally, the price of money. When those rates are driven to zero, or somewhere below zero, and remain there for a prolonged period, asset prices adapt and adjust accordingly.

While it may sound absurd to suggest that Fed funds at 2.25% and a balance sheet that’s $7 trillion instead of $8 trillion somehow constitutes “tight” policy, those levels would force a dramatic repricing of assets. It’s that repricing (in credit spreads and equities, for example) that can then propagate into tighter financial conditions.

You’d think this would be obvious to policymakers and I’m quite sure that, conceptually anyway, it is. However, what seems to have gone underappreciated a dozen years ago is the potential for markets to become hyper-optimized around the post-Lehman policy dynamic. Everything is self-referential and predicated on established behavioral patterns by all parties involved.

Although equities appeared to dismiss it (perhaps on the assumption that rates will convey the message), the BOE is on the brink of challenging that status quo with preemptive rate hikes.

There are myriad reasons why such a move could turn out to be a policy mistake. While the MPC is doubtlessly aware of the most obvious such risks (e.g., the UK is forced back into lockdown and/or rate hikes prove ineffective in the face of cost-push inflation), they may be underestimating the biggest risk of all — that associated with deviating from the behavioral patterns that define and govern markets in the post-Lehman world.

Read more:

UK Faces Nightmare Dilemma With Inflation Gauge At 25-Year High

Rate Hike Threats, Surging Inflation Dominate Headlines

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8 thoughts on “Underestimating The Biggest Risk Of All

  1. Given the relatively small size of the UK GDP ($3T), it seems that US equities markets won’t care much about their rate increase.
    A little scarier for US equities if one of the largest 3 raise rates.
    Approximate nominal GDP in 2021 for the 5 largest: US ($23T), EU ($18T), China ($17T), Japan ($5T) and UK ($3T).

  2. US should be glad to see UK talking the lead in raising rates. If it goes badly, limited scope of harm to US or global markets – I think. If it goes well, markets may be less fearful of similar later moves by Fed. Either way, the Fed can draw lessons.

  3. This was a particularly interesting post for me, because I didn’t know what the “shadow rate” is. Here is what I found – not that I really understand it, but charts are nice to look at: https://www.atlantafed.org/cqer/research/wu-xia-shadow-federal-funds-rate

    Anyway, comparing that chart to SP50, seems like 2014-2016 tapering coincided with a choppy market (high single-digit drawdowns) and the 2018 correction (high teens) was when Fed Funds approached 200bp?

  4. I can never understand the Feds desire to “normalize” the balance sheet. For a long time the balance sheet was likely far too small. Think in real terms. Inflation shrank the real value of the balance sheet for years post ww 2. The easiest out for the fed is at some point when the taper ends, just keep the balance sheet steady. With the nominal economic growth at 4-5% per year the size of the balance sheet will be lower in relation to gdp fairly quickly. And the market won’t panic. There really is no reason to shrink the balance sheet. At that point just raise short term reference rates if you need to tighten policy.

  5. “While it may sound absurd to suggest that Fed funds at 2.25% and a balance sheet that’s $7 trillion instead of $8 trillion somehow constitutes ‘tight’ policy, those levels would force a dramatic repricing of assets.” Yes the fact–and based on prevailing models it is a fact–that FF@2.25%=”tight policy” does sound absurd. I doubt the Fed has the guts to shift gradually to a new regime but I hope they risk it. Most likely expectations that such a policy change causes a market collapse, etc., are wrong.

  6. The Fed just has to move slowly enough (“out of an abundance of caution”) and stay just responsible enough on rates/balance sheet until investors, politicians, voters and, most importantly, the global population who believes in the USD, figure out that not only do we not need to normalize, we can actually continue down this road.

    Is the Fed telling the holders of USDs what it thinks we want to hear, without any intention of following through at that level, unless they are effectively forced? Beliefs not only can but they do change (e.g. voting rights of women, the gold standard, etc).

    Maintaining the world’s trust in USD is more dependent on what we use the USD for than how many are printed. Reducing human generated carbon emissions would be a good start. The UN’s IPCC (intergovernmental panel on climate change) has some interesting models which show a positive correlation between a reduction in human-caused greenhouse gases and an increase in global GDP. There are a lot of assumptions (including population growth) behind those graphs, but it would be a “win-win”.

NEWSROOM crewneck & prints