As you might have noticed, the Fed made a policy mistake in December.
We could delve deeply into the specifics, but quite frankly it all boils down to this: Yellen hiked right into a recession.
There’s more to it than that obviously, including the fact that EM is circling the drain amid the global commodities rout, meaning excessive USD strength is especially damaging and the fact that the uncertainty swirling around the depth of the ongoing yuan devaluation has markets on edge from Shanghai to London to New York.
Put simply: nothing has gone as it should since liftoff. Stocks sold off dramatically in January signaling the Fed failed to convey a sense of confidence in the US economic recovery (which, if good news was indeed good news again should have triggered risk-on sentiment) and yields on the 10-year have plunged since the start of the year (Marc Faber has been exactly right so far).
Meanwhile, the monetary policy divergence between the Fed and the BoJ and ECB has only grown and we learned late last month that the US economy only managed to grow at a 0.69% pace in Q4 (we suppose the BEA are "fiction peddlers").
So with the pressure mounting, and with Janet Yellen having failed (miserably) to reassure the market with her testimony on Capitol Hill earlier this month, what’s in the cards for the Fed if the situation (both in financial markets and in the real economy) continues to deteriorate?
Here to explain “Plan B” (i.e. the steps the Fed will take “when push comes to shove”), is BofA.
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As they scramble to come up with a “plan B,” the Fed has been rather cagey about how they would respond to a serious weakening of the economy or financial conditions. There are two related paths for policy: measures designed to help market functioning, and macro policies designed to stimulate the economy and reverse a market meltdown. On the former, Dodd-Frank has limited the Fed’s room to maneuver; in particular, they can’t take actions that involve absorbing credit risk. However, we would expect them to adopt a variety of liquidity tools if market functioning becomes erratic. Vice Chair Fischer gave a speech last week detailing the options available to the Fed and noting that “broad-based facilities... could still be introduced under our new regulation if they were needed.” At the extreme there could be some easing of recent regulatory rules that have hurt liquidity in the bond market.
In terms of “macro” policy we would expect the following sequence:
- Soft guidance: this is essentially where the Fed is now, underscoring data dependence and hinting that they are unlikely to hike in a turbulent environment.
- On hold: the Fed is getting close to signaling an indefinite lag before its next policy move. This next step would also involve a more forceful statement of policy options (ie, they will tell us more about what steps 3, 4, 5 and 6 are).
- Cut rates back to near-zero and strong guidance: if the equity market drops into a full bear market (or there is some other equivalent financial tightening) or if growth seems to be slowing to a sustained 1%, the Fed would likely cut and remain on hold until the financial/economic weakness reverses. They could introduce a nominal income growth target or price level target to signal an accommodative path for rates well into the future.
- Operation twist two: actively manage the Fed’s portfolio to extend duration, similar to the 2012 Maturity Extension Program. With $408 bn in assets maturing over the next two years the Fed could do the twist by either reinvesting these assets at the long end or, if they want to be more aggressive, also selling short-dated assets before they mature.
- QE4: begin buying Treasury assets at least at the $40bn per month pace of QE3. Could also buy agency-based debt and MBS if the housing market wobbled. (The Fed purchased $45bn per month of MBS during QE3.) Like QE3, purchases would be open-ended and would conclude once a sustained recovery in economic and/or financial conditions occurs.
- Negative rates: if all else fails, they would move into the uncertain world of negative rates. If banks are under serious stress, such a move could be delayed or shelved.
It is hard to summarize all these actions into one statistic. The Fed could cut the funds rate by say 88 bp (from 38bp to -50 bp), although the net benefit of going negative may be quite low. But that is not all. US 10 year yields are about 150 bp higher than yields in Germany and Japan. Roughly speaking, we think the Fed has Fed funds-equivalent of about 150 to 200 bp of easing. That is small relative to the normal recession response, but much bigger than the normal response to financial stress or a “growth recession.”
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Yes, 150 to 200 bps most certainly is "small" compared to the counter-cyclical maneuverability policy makers would have had before the world went Keynesian crazy, but thanks to eight years spent chasing down the Krugman rabbit hole, there's nothing left but NIRP.
If the abysmal pace of global growth and trade as well as the severity of the disinflationary impulse is any guide, Janet Yellen is going to need a bigger "Plan B."