5 August 2015

Yellen the forward guidance

Since the 2008 GFC, or Global Financial Crisis, the Fed has attempted to stem a deflationary spiral with loose monetary policy

by John Royden

Head of Research


The first tool to fight deflation was low interest rates, which encourages people to do things with their money rather than leave it in the bank. The second tool was Quantitative Easing, or QE. The Fed printed $3.4 billion which it issued to buy US Treasuries. It also sold $600 million of short term debt and bought long term debt, as part of operation Twist.

When things started looking a bit deflationary again, the last tool in the box was forward guidance.

The Fed could not really lower rates much more below the target 0.25% so when it considered that it had done enough QE, the only way to affect people’s behaviour was to promise them low interest rates for a longer time into the future. This attempt to influence behaviour is called forward guidance and, from where I stand, slightly lost its appeal and credibility when the Central Bankers started giving forward guidance on forward guidance.

As a Central Banker, you start to reverse out of that process by promising people higher rates than what the market expects and then, in theory, reverse the QE and then the interest rates. 

We have seen the Fed officials’ forward guidance manifest itself as those dot matrix plots. However most believe that interest rates will get done before QE gets reversed.

The worry is that the Fed needs to get “things back to normal” before the next recession because they are fast running out of tools to fight the next recession. If interest rates are close to zero, you have QEed your balance sheet to the limit and you promise zero interest rates to infinity, then what else is left?

My own view is that the Fed probably has more tools to tackle another round of deflation. It can take interest rates negative and it can do more QE. It could give banks the option to borrow at lower interest rates for longer rather than just talking about it: forward promises rather than forward guidance.

So, is the next recession around the corner? Deflation looms on the horizon as China slows from leverage financed growth and commodity prices fall with the slower demand. Oil is down at $45 from a 2013 high of $110.  Iron ore sells for $54 per ton, from $160 in 2013. 

This of course begs the question of whether the Fed should have tightened more in early 2014 when a growing US economy was clocking close to 3% GDP growth and inflation was at 2%. Growth today is still robust enough but inflation is way down at the 0% level. 

The hope is that wage inflation starts the inflationary cycle rolling again and that this is the metric to watch. Many puzzle as to why this is not higher with unemployment down at the 5.3% level.

Again my own view is that the Fed was right not to tighten more in the past and that it’s creative minds will be able to devise more monetary tools to block any more deflationary forces. This could drive productivity lower and slower for longer but I think that is better than taking the hit on the chin with a deflationary spiral of destruction.


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