Has The Fed Run Out Of Ammo?

Over the last few years, some economists have argued the Fed has run out of ammo.1 They say the Fed has already used all its bullets engineering a recovery from The Great Recession. The argument goes something like this…

During the past nine recessions, the Fed has cut the federal funds rate by about 5 and a half percentage points on average.2 Since interest rates are already close to zero, the Fed has less room to cut rates. And, because it has already expanded its balance sheet by more than $3 trillion, it will be harder to launch other rounds of its asset purchase program known as quantitative easing (QE). In other words, the Fed will have fewer monetary weapons to respond to the next recession.

It’s a reasonable argument. But, if you look at what’s going on around the globe with other central banks, you might reach a different conclusion. Based on these observations there are at least three actions the Fed could take to try to stimulate the economy during the next downturn. Let’s take a look at them…

Quantitative Easing On Steroids
First, the Fed could implement a more aggressive round of its asset purchase program. Because of all the previous rounds of QE, the size of the Fed’s balance sheet has exploded in recent years. But, the truth is, the European Central Bank (ECB) and the Bank of Japan (BOJ) have been even more aggressive than the Fed.

The balance sheet of both the ECB and the BOJ have reached more than 80% of their respective gross domestic products (GDP). Some economists are projecting that ratio to hit 100% by 2018. By way of comparison, the size of the Fed’s balance sheet is now equivalent to 65% of U.S. GDP.3

Just look at what the BOJ is doing. Its asset purchase program went from buying just government bonds to exchange-traded funds (ETFs) listed on the Japanese stock exchange.4 Here’s how Bloomberg reports the BOJ’s actions:

“Already a top-five owner of 81 companies in Japan’s Nikkei 225 Stock Average, the BOJ is on course to become the No. 1 shareholder in 55 of those firms by the end of next year, according to estimates compiled by Bloomberg from the central bank’s exchange-traded fund holdings.”5

The bottom line is that there’s nothing preventing the Fed from following in the BOJ’s footsteps during the next economic downturn. Aside from buying Treasury bonds, they could also buy other assets, such as ETFs. In other words, they could implement another round of QE, but a more aggressive version.

Negative Interest Rates
Interest rates are already close to zero. But, could they drop below zero in the future? Federal Reserve Chair Janet Yellen has confirmed the Fed isn’t considering negative interest rates at this point. But, she also hasn’t ruled it out in the future. In response to questions from the Senate, she said: “While I would not completely rule out the use of negative interest rates in some future very adverse scenario, policy makers would need to consider a wide range of issues before employing this tool in the United States, including the potential for unintended consequences.”6

More recently, Fed Vice Chair Stanley Fischer said that we’re in an environment where negative interest rates “seem to work.”7 And, during the Fed’s recent annual economic policy symposium in Jackson Hole, there was an entire session called “Negative Nominal Interest Rates.” During that session, the lead presenter, Marvin Goodfriend of Carnegie Mellon University, made the following remarks: “Negative nominal interest rates can be made freely available and fully effective as a realistic policy option in a future crisis.”8

Based on these commentaries, it seems that negative interest rates could be considered as a monetary tool during the next downturn.

Forward Guidance
Another tool the Fed could use is language. For example, the Fed could drive market expectations simply by promising to keep interest rates at low levels for far longer than anyone expects. Economists from the Fed have confirmed that’s a possibility.

The Fed’s Divisions of Research & Statistics and Monetary Affairs recently published a paper entitled “Gauging the Ability of the FOMC [Federal Open Market Committee] to Respond to Future Recessions.” The paper concluded:

“The federal funds rate now appears likely to settle down over the next few years at a rather low level by historical standards, thereby limiting the ability of future policymakers to support real activity and inflation through lower short-term interest rates in the event of an economic downturn. Nevertheless, even in fairly adverse circumstances, the FOMC should be able to compensate by using large-scale asset purchases and ‘lower-for-longer’ forward guidance about the federal funds rate to put additional downward pressure on longer-term interest rates.”9

As readers of the Daily Pfennig® newsletter can see, it seems the Fed has not necessarily run out of ammo. Whether those policies would work or not is an entirely different debate. We’re simply pointing out the fact that the Fed could implement any or all of these monetary policies during the next downturn. And, if that becomes a reality, it could have important implications for all asset classes.

What steps do you think the Fed is most likely to take with the next market downturn?

Until the next Daily Pfennig® edition…

Tim Smith
Vice President
EverBank World Markets, a division of EverBank