1. Negative real rates essentially becomes an explicit policy objective.
2. The new policy introduces an element of a ‘make-up’ strategy to inflation but characterizes the approach as “flexible”. There is no formulaic commitment (both in terms of the extent of ‘tolerable’ inflation overshoot and the length of time the overshoot can be ‘tolerated’). We think this preserves optionality for the Fed, as one would expect different degrees of tolerance depending on the sustainability and nature of inflation (demand/supply-led for example).
3. Retaining this optionality comes with its inherent trade-off. We think this complicates forward guidance (essentially both a calendar-based/outcome-based forward guidance may be less relevant/useful) as it leaves the framework open to interpretation, alongside a very high degree of subjectivity. The new policy framework may entail different policy considerations for FOMC members with differing views and a clearly-communicated context underlying future policy decisions will be needed – notwithstanding the lack of consensus even within the Committee.
4. The relationship between UE and inflation has been re-assessed. This is partly an acknowledgement that the 2015 rates hikes were, on hindsight, premature. Policy response towards the UE rate – and its relationship with the un-observable NAIRU – will change. The FOMC now defines the “maximum level of employment” as ‘a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market.’ Through that statement, the Fed explicitly recognizes that a focus on headline inflation fails to account for higher unemployment among disadvantaged populations. It also means a low UE rate, by itself, will be insufficient to justify tighter policy without sustained inflationary pressures. Technically, the change embeds an asymmetric policy response to the labor market, changing the policy rule term within Taylor Rule from (u* – u) to min(u* – u, 0). Unemployment higher than NAIRU leads to policy accommodation while the term drops off once it falls below without any corresponding policy tightening post recovery into expansions.
5. The formalization of the framework review will soon be followed up by an update of the Fed’s toolkit. The recent Fed minutes suggest that the addition of some form of Yield Curve Control/Targeting (YCC/YCT) into the toolkit is not imminent (understandably so given the lack of incremental benefits at this juncture). We note that adding YCC to the toolkit ≠ utilization. That said, YCC may be inevitable at some point should underlying conditions force further sustained balance sheet expansion – given the inherent technical constraints of QE (such as the proportion of excess reserves in the banking system’s balance sheet). YCC, we believe, is highly likely to come before negative policy rates is even contemplated.
6. The promise to tolerate higher inflation vis-à-vis the ability to generate higher inflation are two separate issues. Current underlying conditions (higher debt stock -> debt deflation, lack of aggregate demand, no wage-driven inflation, the strengthening of big vs. small -> oligopolistic nature of economy etc., no meaningful global re-balancing) are significant impediments to generating sustainable demand-led inflation. Inflation, at best, will likely be sector-specific (sectors most meaningfully impacted by Covid-19 on the supply-side – staples/commods, or see one-off demand spike – healthcare, logistics, personal transport vehicles), and which will mostly be offset by weaker spending elsewhere. Unfortunately, AIT works best in a typical late-cycle expansion (when Fed’s credibility will be most critical) – this is not a valid consideration at this juncture, with employment/inflation way below target, and effective transmission of monetary policy suspect. Hence, less relevant considering current circumstances. Moreover, it allows a bear-steepener during better times, which helps restore profitability to the financial system (vs. a typical bear-flattener without AIT), but similarly less relevant considering current circumstances.
7. On a standalone basis, the formalization of the AIT framework resembles more an intensification of the current regime, rather than a regime shift, especially once we consider the overall policy mix both globally and domestically. Incrementally, it justifies a marginal higher move in breakevens, a steeper curve but at an un-stable/fragile equilibrium (we have previously argued here for why the current regime is unsustainable and a shift imminent/inevitable), but nothing much beyond.
8. We continue to expect a deeper state of financial repression. However, underlying conditions are unlikely to allow CB-engineered financial repression – on its own – to work this time round (which we define as the ability to generate higher demand-led income growth and subsequently deleveraging via ‘healthy inflation’). Instead, side effects will intensify – such as elevated leverage, wealth disparity, reversal rates, zombification, anti-competition – hence leading to shortened future cycles – with less/zero scope for monetary policy offset. Real rates can stay negative even as disinflationary pressures persist, but clearly only to a very limited extent.
9. The Fed put is, however, still operational, should the sell-off be driven by adverse market functioning and not economic downturn. The Fed can support markets by being the bidder-of-last-resort in thin markets. While its credit guarantee programs are extremely powerful (defers default driven by liquidity and protects FIs through risk transfer), insolvency driven by a prolonged downturn will still damage markets through spill-overs (limited Fed ability to short circuit solvency led sell-off). The Fed has limited space, if any, to support income – either through lower debt-servicing or by driving higher demand (broken policy transmission).
10. That said, it is now difficult to envisage an environment whereby the ground is more fertile for well-designed fiscal policies than the current one. Politics now favor income support to the consuming class, financing costs are low, there are high buffers to inflation constraints, and now a credible assurance that fiscal spend will not encounter a counteracting monetary policy from the Fed. The O/N move in rates on the day of the announcement suggested some optimism towards a post-election fiscal outcome.
Implications on Rates Markets
– The tightened control at the front-end of the curve – & assuming the ZLB stays – will increasingly limit the possibilities in which the spot curve can move. We expect the long-ends to increasingly lead any directional move from here on, with the curve only capable of meaningful bear-steepening/bull-flattening as conditions improve/deteriorate. A meaningful bull-steepener will require deeply negative rates (in this instance, the forward curve may remain stable via a much steeper curve which is negative in absolute terms, but clearly the hurdle is very high at the current juncture); whereas under the new framework, a meaningful bear-flattener will perhaps be years away.
– Clean positioning and low absolute levels pricing to near-perfection (suppressed term premia + positive odds for negative rates priced) suggests that the hurdle to higher rates is un-demanding. The extent, however, will be capped by the overwhelming dis-inflationary dynamics of the current regime.
– A much more meaningful move higher in our anchor levels for rates will require a shift in policy regime (confidence over a Treasury-Fed coordination needs to intensify, and subsequently, proven) – depending on political dynamics. The fiscal outlook will play an outsized role in determining the trajectory of markets, including rates, depending on the outcome of the Nov US elections. Should fiscal activism gain ascendency, the role of the Fed as either fiscal enabler or as a “responsible and independent” institute (which the new framework dilutes to an extent) counteracting fiscal authorities will be important in deciding the success of the fiscal program and the trajectory of rates.
– Higher rates will also require policy regime shifts beyond the US. We note the increasing recognition by major surplus countries to focus on generating more sustainable sources of domestic demand. Developments such as the EU Recovery Fund, the relatively quick and expansionary fiscal response in the EU and increased signaling by Chinese authorities on the need to close the income gap and rebalance towards domestic demand are the positive signs. The above are conditions necessary for a ‘Great Reset’, but only if they persist in a greater scale and highly dependent on a sustained shift in political-economic philosophy and policy execution.
– We will seek to explain policy regime shifts and their implications in future posts.
