Janet Yellen, the Federal Reserve chair, has warned that there is an “uncomfortably high” risk that the central bank will have to deploy crisis-era stimulus tools again — even in the case of a less severe downturn than the Great Recession.You should all take the time to read Janet Yellen's speech, A Challenging Decade and a Question for the Future, which is available here. Below, I note her conclusion:
Her comments come as President Donald Trump considers a sharp change of direction at the Fed which could see him install new leadership that is much more dubious about the Fed’s use of quantitative easing.
Ms Yellen said in a speech that the US economy had made “great strides” but that policymakers may be unable to lift short-term rates very far as the recovery proceeds.
This could leave the Fed once again leaning on quantitative easing and forward guidance on the future rate outlook when the economy hits a downturn, she suggested.
“The probability that short-term interest rates may need to be reduced to their effective lower bound at some point is uncomfortably high, even in the absence of a major financial and economic crisis,” she said in a speech in Washington DC.
Former Fed governor Kevin Warsh and John Taylor, a Stanford University economist, are among those who have criticised the US central bank’s decision to swell its balance sheet to $4.5tn as it battled the crisis. Both are candidates to take over from Ms Yellen if Mr Trump declines to give her a second term when her current one expires in February.
Conservative lawmakers on Capitol Hill have also long been critical of the Fed’s unconventional monetary policy, and some have warned that the Fed was risking a major flare-up in inflation and asset bubbles because of its stimulus programmes. Some GOP lawmakers have been agitating for a new regime at the Fed, signalling support for both Mr Taylor and Mr Warsh.
Mr Trump has signalled a decision on a new Fed chair could come soon, and in an interview with Fox Business to be broadcast this weekend the president suggested Ms Yellen remains in contention for a second term. Mr Trump also singled out Mr Taylor and Jay Powell, who is currently on the Fed board, and hinted that they are leading candidates.
The president added that there are a couple of other contenders, whom he did not name. They are likely to be Mr Warsh and Gary Cohn, the director of the National Economic Council.
In her speech, Ms Yellen pointed out that most Fed policymakers only expect to lift the federal funds rate to about 2.75 per cent in the coming years, well below previous norms, suggesting there will be little room to cut rates again when a new downturn strikes. This meant the Fed needed to remain prepared to deploy new rounds of asset purchases.
She also defended the Fed’s payment of interest on excess reserves held by commercial banks — an unpopular mechanism with some lawmakers but one that has allowed it to set rates without being forced to dramatically cut the size of its balance sheet.
Ms Yellen said unconventional policy should be used once again if the Fed has to cut its target range for the federal funds rate to near-zero levels, from about 1-1.25 per cent now.
“Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades,” Ms Yellen said.
“The bottom line is that we must recognise that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound.”
Let me conclude with a brief summary. As a result of the Great Recession, the Federal Reserve has confronted two key challenges over the past several years: One, the FOMC had to provide additional policy accommodation after short-term interest rates reached their effective lower bound; and two, subsequently, as we made progress toward the achievement of our mandate, we had to start scaling back that accommodation in the presence of a vastly expanded Federal Reserve balance sheet.Now, there's a lot of confusion out there so let me skip straight to my conclusion: this time next year, the Fed will firmly be entrenched in QE infinity. Mark it, it's coming and maybe that's why stocks keep melting up, for now.
Today I highlighted two points about the FOMC's experience with those challenges. First, the monetary policy tools that the Federal Reserve deployed in the immediate aftermath of the crisis--explicit forward rate guidance, large-scale asset purchases, and the payment of interest on excess reserves--have helped us overcome these challenges.
Second, in light of evidence suggesting that the neutral level of short-term interest rates is significantly lower than it was in previous decades, the likelihood that future monetary policymakers will have to confront those two challenges again is uncomfortably high. For this reason, we must keep our unconventional policy tools ready to be deployed again should short-term interest rates return to their effective lower bound.
You got that? Forget all this nonsense of reflation, deflation is alive and well, and with markets on the edge of a cliff, it's silly to think the Fed will continue raising rates and shrinking its balance sheet over the next year, especially if deflation strikes the US and brings about the worst bear market ever.
I say this knowing full well about the $2.5 Trillion Paradox: "While The Short End Is Optimistic, The Long End Has Never Been More Pessimistic".
For me, there is no paradox, the long end has it right when it comes to the inflation-deflation mystery and everyone else will get crushed. Obliterated is more like it but central banks are putting up a good fight, one that they're desperately trying to win using any conventional and unconventional means necessary.
Unfortunately, the real paradox is as central banks keep buying risk assets (stocks, bonds, etc.) to prop up the global financial system (ie. big banks and their big hedge fund and private equity clients), all they're doing is delaying the inevitable, which is a good old fashion retrenchment and purging of the system.
Over the weekend, Jesse Colombo, Economic Analyst and Forbes writer, posted this on LinkedIn (click on image):
It generated quite a few responses but the point is central banks expanding their balance sheet have allowed corporate bond markets to rally, allowing companies to buy back shares like there's no tomorrow, fuelling the passive $3 now $4 trillion beta bubble and an asset-stripping boom in private equity. In other words, it's all related.
If you plot the expansion of all central banks' balance sheet (including China's) as a percentage of global total market capitalization (stocks and bonds), you will see why these aren't grandma and granpa's markets. They're heavily manipulated by central banks and hedge fund quants taking over the world.
This is why I remain highly skeptical of those who warn of the "big, bad bond bubble" and there are plenty spreading this nonsense, including those that wrote the latest monthly commentary from IceCap Asset Management, Should I Stay or Should I Go?.
Chris Cole, CIO of Artemis Capital, published a great comment, Volatility and the Alchemy of Risk, which explains how the global short volatility trade has now surpassed $2 trillion and will eventually wreak havoc once it's unwound.
I know all about the silence of the VIX but markets can stay irrational longer than Chris Cole et al. can stay solvent.
Still, things are getting very stretched. I don't want to alarm anyone but I beefed up my comment on markets on the edge of a cliff and I'm getting this really eery feeling that all hell is about to break loose.
To all you warriors trading these markets, stay nimble, don't get greedy, the music is still playing but the sound quality is terrible. Come out to play at your own risk and get ready for QE infinity.