Potency of the Fed Put: Then and Now
This reloaded Fed is a shadow of its former self.
After using much of its available ammo to fight off the 2008 financial crisis and recession, the Fed has spent the past few years trying to reload to be ready for the next ones. But the policy normalization process that the Fed embarked on at the end of 2015 appears to have come an end.
Coming out of its March meeting, in addition to communicating a posture of patience in making future rate adjustments, the Fed also announced that it will end its balance sheet run off later this year.
Whether or not the Fed actually considers policy to be normalized isn’t entirely clear; but for now, the policy normalization process is done.
Confirmation of its dovish stance sent markets higher. After all, a 2.5% fed funds rate and a $4 trillion balance sheet are, by historical standards, highly accommodative.
The circumstance, however, does make one wonder: is the economy still so weak as to need so much monetary accommodation, or is the notion of ‘neutral’ policy simply lower in the post crisis era?
In any event, investors applauded the announcement, pushing equity markets sharply higher the following day. If the reasons to be bullish were self-evident, reasons for concern may not have been so readily apparent.
One risk of the current policy stance is that it leaves the Fed with much less firepower to respond to the next crisis. In 2007, the fed funds rate was more than double what it is today, while the size of the balance sheet was less than one-quarter of today’s size.
This has at least two significant implications:
1. Relative to 2007, the Fed today has fewer available rate cuts at its disposal before reaching zero.
2. Today the Fed’s $4 trillion balance sheet, including $1.6 trillion in excess reserves, suggests that QE, as a means of injecting liquidity, won’t have the same potency that it did at the start of QE in 2008.
Combined, these conditions suggest that the Fed’s ability to act as the market’s ‘back stop’ or ‘put option’ against the next downturn is substantially diminished.
Unless otherwise noted, data is sourced from Bloomberg.
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