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Monetary Policy and its

Impact on Financial Assets September 9, 2016

Over the past few months, members of the US Federal Open Market Committee (FOMC) have been signaling a change in their views regarding the current stance of monetary policy. In a recent article1 Ben Bernanke the former Fed President has made the case that the Fed’s shift in policy reflects structural changes in the US economy – not fluctuations in monthly economic data releases. This shift in thinking explains the recent dovish views of several FOMC members and their willingness to hold interest rates lower for a longer period of time than previously anticipated. More importantly, it also explains why interest rates in the current cycle do not have to rise by as much as past cycles. In this note we explain in detail what has changed in the Fed’s monetary policy framework and why. We focus particularly in the decline of the equilibrium real interest rate over the past thirty years and attempt to account for the factors that have driven this decline. Prolonged periods of low interest rates have potential side effects, especially for the pricing and riskiness of financial assets. Policymakers are aware of these side effects, therefore the current low rate environment will not continue forever. The exact process of how policy makers exit the current low rate environment will have profound impact on financial assets and stock markets in particular. Empirical evidence suggests that over the past twenty years the impact of monetary policy decisions on equity markets has been substantial and anticipated by equity markets prior to policy announcements.

Changes in the Fed’s monetary policy framework The shift in policy comes from significant revisions in the expected long-run values of three key economic variables:

The potential output growth y*, which can be thought of as an estimate of the economy’s attainable rate of growth in the long run when resources are fully utilized;

The “natural” rate of unemployment u*, which is the rate of unemployment that can be sustained in the long run without generating inflationary or deflationary pressures; and

The “neutral” federal funds rate r*, which is the level of interest rates consistent with stable, long-term non-inflationary growth.

Estimates for all three variables have been revised meaningfully lower relative to their levels in 2012. The potential output growth y* is expected to be 1.8%-2.0% per year vs. 2.3%-2.5% in 2012, the natural rate of unemployment u* 4.7%-5.0% vs. 5.2-6.0% and the neutral federal funds rate r* 3.0% vs. 4.25%. For understanding future monetary policy, the interesting question is why the views of the FOMC have changed and why now, given that all three variables are largely out of the control of the central bank2. In his article Ben Bernanke hints at the main reason for the shift: “The changing views of FOMC participants (and of most outside economists) follow pretty directly from persistent errors in forecasting economic

1 Bernanke, B., (2016): “The Fed's shifting perspective on the economy and its implications for monetary policy", Ben Bernanke's Blog, https://www.brookings.edu/blog/ben-bernanke/2016/08/08/the-feds-shifting-perspective-on-the-economy-and-its-implications-for-monetary-policy/ 2 We thank Ray Zemon for stimulating discussions on this issue.

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developments in recent years” (emphasis is ours)3. In other words, the Fed has been surprised by both economic growth and wage growth being persistently below their expectations. The US potential output growth y* has been reduced as the pace of productivity and labor supply growth have slowed significantly. And the fact that inflation has been lower than forecasts in recent years despite very low unemployment rates implies that the natural rate of unemployment u* is lower than previously thought. As a result, the FOMC views the current accommodative monetary policy as appropriate for this stage of the business cycle. This is a departure from the pre-2008 monetary policy reaction function. The Fed will maintain the current monetary policy until growth meets their expectations. But this is nonsensical as the Fed has no ability to influence potential GDP growth or the natural rate of unemployment! Therefore maintaining the current monetary policy requires a (short-term) rational justification for doing so. Several such justifications have been provided by members of the FOMC, all of them consistent with the belief that Fed actions should in no way lead to negative surprises in financial markets. Of these justifications, the lower neutral real fed funds rate is the most important one. It implies that the actual real federal funds rate is only modestly below the neutral real rate and hence the present stance of monetary policy should be viewed as modestly accommodative. A lower value of r* has two big implications for monetary policy. Firstly, current policy is not as accommodative as previously thought since the actual real federal funds rate is only modestly below the neutral real rate. Second, the pace of monetary policy tightening required for reaching the neutral fed funds rate can be slower as the “distance” to target that the funds rate need to travel is now shorter. Another justification for the shift in monetary policy comes from the fact that inflation isn’t rising, despite the fact that current monetary policy continues to be accommodative. This implies that the economy still has significant underutilized resources and is currently growing below potential. Such thinking ignores that consumer prices are sticky and that monetary policy impacts inflation with a significant lag. A final justification comes from external factors, namely the importance of global deflation risks coming from China and Europe4. Deflation risks imply a prolonged period of aggressively easy monetary policy outside the US, and consequently a stronger US dollar. The Fed cannot ignore the impact of the USD in setting US interest rates. Effectively the US equilibrium interest rate has been reduced by events overseas. The equilibrium real interest rate (natural rate) One of the most important variables in setting interest rates is the equilibrium real interest rate. The concept was introduced in the late nineteenth century by the Swedish economist Knut Wicksell. It is defined as the real (i.e. adjusted for inflation) interest rate consistent with the economy operating at its full potential. This definition takes a “longer-run” perspective; it refers to the level of real interest rates expected to prevail, say, 10 years in the future, and is not concerned with the impact of transitory shocks on aggregate supply or demand. Estimating the natural rate of interest is difficult because it changes over time due to various factors, some of which are unobservable5. Furthermore, the natural rate exhibits no clear tendency to revert to a fixed long-run mean (it is non-stationary). As a result, estimates of the natural rate are highly uncertain. Nevertheless, over the past few years, economists have made significant progress in modeling and understanding the behavior of the natural rate.

3 Bernanke, B., (2016), ibid. 4 Gavyn Davies (2016): “What caused the Fed's dovish turn”, Fulcrum Research Note. 5 Hamilton, James D., et.al. (2015) : “The Equilibrium Real Funds Rate: Past, Present, and Future.” Presented at the

U.S. Monetary Policy Forum, New York, February 27 (revised May 2016). https://research.chicagobooth.edu/igm/usmpf/2015.aspx

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The following graph shows estimates of the natural rate for the US using the so called Laubach-Williams model6. It also shows the real Fed Funds rate (deflated using the Core PCE measure of inflation).

Source: Laubach & Williams (2015)

What is striking is the significant decline of the natural rate over the past thirty years and especially in the aftermath of the global financial crisis. Current estimates of the natural interest rate in the US are close to zero. Large declines in the natural rate of interest have also occurred in other developed economies, Canada, the Euro Area and the United Kingdom7. This implies that global factors – rather than country specific ones – are the likely drivers of the decline in the natural rate. Historically economists attributed changes in the natural rate to changes in the trend growth of an economy. Whilst global trend growth has indeed slowed across economies, its impact cannot account for the magnitude of the decline in the natural rate8. In a recent study, Lukasz Rachel and Thomas Smith9 of the Bank of England identify three broad global factors that drive the neutral rate: changes in global trend (potential) growth; factors shaping preferences for desired savings; and factors shaping preferences for desired investment. The two charts below account for the drop in the natural rate over the past thirty years by quantifying shifts in these three factors. On Rachel and Smith’s estimates, these factors combined account for approximately 400bps of the decline in the natural rate. The desired savings schedule has shifted out

6 Laubach, Thomas, and John C. Williams, (2015): “Measuring the Natural Rate of Interest Redux.” FRB San Francisco

Working Paper 2015-16, October, forthcoming in Business Economics. http://www.frbsf.org/economicresearch/publications/working-papers/wp2015-16.pdf and Williams John C., (2015): “The Decline in the Natural Rate of Interest”. http://www.frbsf.org/economic-research/economists/jwilliams/Williams_NABE_2015_natural_rate_FRBSF.pdf John Williams is the president of the Federal Reserve Board of San Francisco and one of the leading authorities at the Fed on the topic of the natural rate. 7 Holston, Kathryn, et.al. (2016): “Measuring the Natural Rate of Interest: International Trends and Determinants”, FRBSF Working Paper 2016-11, June. http://www.frbsf.org/economicresearch/publications/working-papers/wp2016-11.pdf 8 Hamilton, James D., et.al. ibid. 9 Rachel, Lukasz, and Thomas D. Smith, (2015): “Secular Drivers of the Global Real Interest Rate”, Bank of England Staff

Working Paper 571, December. http://www.bankofengland.co.uk/research/Pages/workingpapers/2015/swp571.aspx

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materially owing to demographic forces (explain 90bps of the fall in real rates), higher inequality within countries (45bps) and the emerging markets savings glut (25bps). The natural rate has also been depressed by changes in desired investment due to the decline in the relative price of capital goods (50bps), a preference shift away from public investment projects (20bps), and an increase in the spread between the risk free rate and the return on capital (70bps). Finally, lower potential GDP growth is responsible for approximately an additional 1% drop in the natural rate.

Source: Rachel and Smith (2015)

Whilst real interest rates have fallen in both advanced and emerging economies, the two blocs exhibit different trends in savings and investment, particularly since the late 1990s. Savings and investment as percent of GDP have fallen in advanced economies and risen in emerging ones. This suggests that a shift in the investment schedule has been the driver of moves in real rates in advanced economies, whilst shifts in the saving schedule have been more important for emerging economies. In conclusion, the drop in the natural rate has been driven by fundamental trends which are likely to persist in the long term and will continue to be highly influential on future monetary policy. Intended and unintended consequences of unconventional monetary policy In a world of low global neutral rates the conduct of monetary policy becomes significantly more challenging, primarily due to the limited ability of monetary policy to accommodate adverse shocks given the zero lower bound on nominal interest rates. In fact, a large-enough shock can lead to an equilibrium where secular stagnation sets in. Policymakers have responded to the current situation in several ways. Many central banks have employed qualitative forward guidance in order to influence expectations. They have also become more reliant on unconventional policy measures such as quantitative easing (QE) and negative interest rates. QE and negative interest rates have potential intended and unintended consequences that limit its effectiveness as a monetary policy tool. The QE-induced portfolio rebalancing effect does lead to broad increases in asset prices thus raising financial wealth. With trillions of dollars of developed-country debt trading at historically low – and in many cases, negative – yields, investors are “forced” to extend duration and increase the riskiness of their portfolio in order to get any yield at all. This reach for yield is based on a set of erroneous and dangerous beliefs which become ever more engrained in investors’ minds in an environment where unconventional monetary policy goes on and on. Investors believe that there is no

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need to really worry about the global economy or the financial system because policymakers will do whatever it takes to keep things under control. In this environment risky assets are trading at extreme valuations, with equities valued at lofty PEs computed on profit margins that are at the high end of their multi-decade range. Profit margins will move lower in the medium term as margins mean revert, especially in the face of political and technological pressures. Elevated equity valuations and the cheap cost of capital incentivize financial engineering (stock buybacks, excessive debt issuance) rather than capital stock expansion. Unconventional monetary policy also raises political and economic concerns regarding the growing size of central bank balance sheets. Negative interest rates act as a tax on wealth, savings and future pensions. The popular belief that inflation is very hard to manufacture by central banks does not imply that inflation does not exist and that it is not eroding household wealth and retirement savings. The low rate environment presents a particular challenge to the business models of banks and insurance companies. Flat yield curves and low rates squeeze commercial banks’ net interest margins, undermining their profitability. Finally, unconventional monetary policy has adversely impacted the liquidity in fixed income markets. Manipulation of securities markets by governments and restrictive regulation has increased the cost of trading and has weakened the ability of markets to provide signals used for the allocation of capital and risk management. Today’s securities markets are not priced to reflect the risks and consequences associated with unconventional monetary policy. The cyclical nature of interest rates and the length of the cycles are not accounted for. Monetary economists accept that both accommodative and unconventional monetary policy distort real and financial decision making. The current debate is whether the potential benefits of such policy outweigh the potential costs. Therefore, the real question for policy makers is whether they can manage to normalize policy before policy induced market distortions become detrimental to the economy. Recent FOMC minutes10 show that several Fed officials worried that an extended period of low interest rates risked intensifying the reach for yield and the resulting misallocation of capital and the mispricing of risk, with adverse consequences for financial stability down the line. In the event that monetary policy tools become constrained or ineffective, fiscal policy may need to play a more active part in business cycle stabilization. Governments should target increasing the desired investment levels directly through increased public investment, and indirectly by raising future growth prospects and encouraging private sector investment. Financing such a fiscal expansion poses a particularly challenging problem, especially for countries with high levels of public debt and limited fiscal room for maneuver. Finally, governments can implement structural reforms that increase productivity and labor supply and raise potential output growth of the economy. Empirical support of the impact of policy decisions on stock returns Empirical evidence of the impact of monetary policy on stock returns since the 1980’s has been provided by a recently published study by David Lucca and Emanuel Moench11. The paper documents surprisingly large average excess returns earned on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the FOMC. These returns have increased over time and account for sizable fractions of the total annual realized stock returns. The figure below shows the average cumulative returns of the S&P 500 index the day before, the day of and the day after FOMC announcements. The sample period is from 1994 to 2011. From close of business to close of business on FOMC announcement days, stock exhibit excess returns (above the risk free rate) on average of about 33 basis points, compared with an average excess return of about 1 basis point on all other days. The effect is even stronger – 49 basis points – if measured intraday between 2pm the day

10 June 2016 FOMC minutes. 11 Lucca, David O., and Emanuel Moench, (2015): The pre-FOMC announcement drift, Journal of Finance 70, 329–371.

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before the announcement and the time of the announcement. Both results are strongly statistically different from zero.

Source: Lucca & Moench (2015)

This result does not apply only to U.S. stocks. Several other international equity indexes display a pre-FOMC announcement drift. Surprisingly, major international stock indices do not exhibit excess returns ahead of their own, local central bank monetary policy announcements. Finally, the effect exists for both easing and tightening decisions. The difference in excess return between the two is not statistically significant. From 1970 to 1993 (prior to when the Fed started releasing its policy decisions right after each meeting) no excess returns existed. Furthermore, there is no similar pattern of differential returns for other asset classes such as short-and long-term fixed-income instruments and exchange rates on FOMC days compared with other days. And no analogous drift is observed ahead of other macroeconomic news releases, such as the employment report and GDP, among others.

Source: Lucca & Moench (2015)

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Contact Information KI CAPITAL GmbH Breitenstrasse 66 8832 Wilen bei Wollerau Switzerland Tel: +41 79 848 8480 Email: kostas@kicapital.ch

The cumulative effect of the pre-FOMC announcement drift on the S&P 500 index is staggering. The figure above shows the S&P 500 index since 1994 with and without the 24-hours of pre-FOMC returns. More than 80 percent of the annual equity premium has been earned over the twenty-four hours preceding scheduled FOMC announcements, which occur only eight times per year. A follow-up study by Peter Chan in 201512 confirmed the existence of the pre-FOMC announcement drift effect in S&P500 returns from 1994 to 2011 using only close to close S&P 500 data. Chan extended the analysis for the “out-of-sample” period April 2011 to January 2015 which included 31 scheduled FOMC meetings. The study finds a positive drift in the out of sample data, but the effect is less pronounced at approximately 25 basis points and furthermore it is not statistically significant. Given the small sample size and the very low variation in the level and direction of policy during this period13, the lack of statistical significance in the out-of-sample study is not surprising14. Concluding remarks Over the past thirty years the neutral real interest rate across developed economies has declined substantially. Evidence suggests that secular rather than transitory factors are driving its decline. A lower neutral interest rate implies that the cumulative amount of tightening required for monetary policy to become neutral is much smaller than previously thought. Markets are currently pricing significantly smaller tightening than even a lower neutral rate would justify. Given the empirical evidence of the impact of monetary policy decisions on stock returns, as the time of monetary policy normalization is nearing, the uncertainty regarding the Fed’s new approach increases the risk of abrupt market moves.

Kostas Iordanidis KI Capital GmbH

12 Chan Peter, (2015): “Update on the Pre-FOMC Announcement Drift” (Wednesday, 4 March). http://www.returnandrisk.com/2015/03/update-on-pre-fomc-announcement-drift.html 13 We thank Elizabeth Rasskazova for pointing this to us. 14 Alternatively the lack of statistical significance in the out-of-sample period can be due to the weakening of the effect after publication of the Lucca and Moench working paper in 2011. Another plausible explanation would be that the FOMC has become more transparent since the discovery of the effect and therefore there is less uncertainty regarding monetary policy decisions, which might lead to a lower risk premium for such events.