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Unconventional monetary policy is now conventional

The speech delivered by Janet Yellen, Chair of the Federal Reserve, on 26 August 2016 at the Jackson Hole symposium titled The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future offered a unique insight into how the Fed (and by implication how other global central banks) will conduct monetary policy in the years ahead.

‘Equilibrium’ cash rate lowest in 50 years

There is a need to build policy resiliency and flexibility, which is especially important with the equilibrium or normal real cash rate materially lower than it has been over the 40 years leading up to the GFC. In practical terms, the normal real cash rate is where inflation is seen to be stable and output on average is close to potential. It is entirely plausible the normal real cash rate is now close to zero, compared to around 2.5% in the past. Significantly, the result is that the scope to raise nominal interest rates to levels that prevailed in past cycles will be very limited and unnecessary given the future prospects for growth and inflation.

The subdued medium-term growth and inflation outlook reflects weaker employment and productivity outcomes inhibiting consumption, a lack of attractive projects for capital investment, and demographic factors such as declining population growth. In some countries such as Japan and across Europe, the issue is more acute and this is where official cash rates have been moved into negative territory. There is strong evidence that negative rates have arrested a steeper decline in output and growth than otherwise – especially in the absence of the political and economic power to expand fiscal policy when sovereign debt burdens were so high.

Janet Yellen has messaged several important thematics shaping the Fed‘s thinking, including the future monetary policy framework which will include an expanded monetary policy toolkit. There is no going back to the conventional and simple adjustments to the policy cash rate. The so-called unconventional monetary policy measures will remain in scope for years to come. This means central banks will have much larger balance sheets, they will continue to use forward guidance, make targeted asset purchases and, as required, change the level of interest rate paid on excess reserves banks hold with the central bank.

Negative rates counterproductive

By its omission, it may be concluded that the US toolkit does not contemplate negative official cash rates. There is mounting evidence that negative rates adversely impact bank profitability which could ultimately weaken the stability of the financial system and at its extreme becomes a tax on savers. In parts of Europe, depositors are paying banks to leave their money on deposit, with a potential adverse impact on investor and consumer confidence. It can encourage distortions in other asset prices as investors hunt for yield.

We are also seeing a divergence in approach across central banks in the tools employed. This reflects a few factors – including weaker inflation and economic performance and the way the credit channel operates in different economies. For example, the European Central Bank, having moved to negative rates and purchased significant proportions of the European sovereign debt market, are now buying corporate debt. This reduces the cost of corporate borrowing by driving yields lower. Yellen’s speech alluded to this approach: the ability if required to expand the types of assets purchased to be added to the toolkit. The Bank of Japan seems set to continue its expansion of balance sheets and further moves into negative rates, although clearly mindful of unintended consequences.

Even if rates rise, the peak will be very low

So where does this end? Not any time soon because there is no real alternative. Rates are set to remain very low for a long time with punctuations of volatility but not a sustained rise. We continue to look for a handoff to fiscal policy and even a recognition that some bank regulation is a disincentive to capital investment and inhibits the free flow of capital. For the Fed, a further policy tightening is likely before end 2016. Yellen refers to the asymmetry of risks and that there is no pre-set path. This is why the Fed’s approach will be gradual and data dependent. The nominal Fed funds rate peak in this cycle may be as low as 2%.


Anne Anderson is Head of Fixed Income at UBS Australia. This article is general information and does not consider any investor’s circumstances.


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