At the beginning of the year, Former Federal Reserve Chairman Ben Bernanke said that the Fed has the tools it needs to fight the next recession. Bernanke also claimed that “The new policy tools are effective,” referring to Quantitative Easing (massive scale asset purchases program by a central bank in order to encourage investment and lending) and Forward Guidance (the communication form of the Fed about the economy and future policy actions, or simply central bank jawboning). On the other hand, as Bloomberg reported the current Chairman Jerome Powell recently suggested that "The Fed May Lack Ammo to Combat Next Recession" and support from fiscal policy (government spending) would be important if the economy weakens. In addition, on February 4 Powell's predecessor Janet Yellen said:

"I worry about low-interest rates because they are a symptom of a deeper problem in the global economy. And it has put central banks in a position where they don't have a lot of ammunition. If we have a serious recession, we're probably not going to be able to count on central banks to offer up a significant response."

There is no doubt that debate among policymakers on whether the monetary policy would be still effective in the next recession is intensively developing. It is important to emphasize that their decisions have significant implications for investment decisions. Having said that I will try to find out if the US Central Bank has enough bullets (and what they are) to fight the next economic downturn.


Interest Rates will not be sufficient

Before I proceed to the main topic I would like to remind the Federal Reserve's main objectives in conducting their policies, those are: 1) maximum employment; 2) stable prices, and 3) moderate long-term interest rates. It is commonly known as a dual mandate as the latter two can be treated together as a 2% inflation target.

In order to achieve those goals, the central banks' main tool is setting the level of interest rates, in other words, the costs of credit. In theory, lower interest rates should encourage lending which spurs investment and spending. In effect, unemployment will decrease and inflation increases as people spend more. In normal economic conditions, this relation holds pretty well. The opposite is true when interest rates are raised. In a period of slowdown or a recession the economic activity substantially slows which leads to higher unemployment and lower inflation or even deflation. Central Bank trying to fight that lowers rates in the hope that economic activity will rebound. In case of a recession, those cuts are conducted in a very aggressive manner. The chart below shows this phenomenon by depicting United States interest rates managed by the Fed over the last two decades.

As you can see during the past two recessions (red areas) the Federal Reserve has cut the rates by more than 5%. Over the last century, the average amount of cuts during economic downturns has been roughly 5.5%. Therefore, what is very conspicuous on the graph is that the current level of interest rates stands at 1.75%. Does that mean the Fed will cut rates to -3.75% in the next economic decline? Not necessarily. US policymakers are fully aware of the adverse consequences of negative rates, especially considering that the dollar is a reserve currency. They probably know that this policy would implode the global economy. In fact, only economic charlatans such as Ben Bernanke are not ruling out this option. 

So, when interest rates are already very low and the Fed cannot cut them to such an extent like during the previous recessions, what other tools the most powerful central bank in the world has in its box?


QUANTITATIVE EASING AKA 'MONEY PRINTING'

Central bankers are often using difficult vocabulary in such a way that the man in the street not interested in the economy on a daily basis would probably not understand some of them in the first place. The reality is that it may take a couple of years to fully understand what their mysterious jawboning actually mean. Let's break down one of them which is Quantitative Easing (QE), which is regarded as the unconventional tool in conducting monetary policy. In QE a central bank purchases assets such as government bonds and mortgage-backed securities (similar assets to bonds that are made up of a bundle of home loans) in case of the Fed (other central banks buy also other assets) from primary dealers (big commercial banks such as JP Morgan) in exchange for created reservers. Bank reserves are its cash holdings, that are physically held by the bank, as well as deposits held in the bank's account (like a deposit account) with the central bank.

It is important to note that those commercial banks are allowed to create loans for roughly ten times the amount of reserves. Thus, in theory, more reserves mean more loans available in the economy. In effect, the money supply in the financial system increases.

In other words, a central bank creates money out of thin air and buys assets from banks. This is why it is commonly called as 'money printing' or 'liquidity injections'. By buying those assets, the central banks also lower longer-term interest rates as a result of which credit is more affordable for banks, companies, and consumers.

Bonds, mortgage-backed securities and different assets bought by the central bank are held on its balance sheet. The Federal Reserve has conducted three QE operations over the last decade which is shown on the chart below (blue areas).
source: Real Investment Advice

Each of these QE programs has resulted in a substantial increase in the total value of assets on the Fed Balance Sheet (orange line) by $3.6 trillion, to as much as $4.5 trillion. In order to simplify the analysis, let's compare the expansion of the balance sheet to the previously mentioned interest rates.

Researchers from the Federal Reserve of Atlanta estimated that even though the US interest rates have been at 0% level the effect of QE programs resulted in a decrease to -3%. The so-called shadow rate still have been affecting the economy while the official US rate (blue) stayed at 0%.

It means, therefore that each $300 billion of asset purchases via QE have been an equivalent of one 0.25% interest rate cut (3% = 12 rate cuts,  12x$300 = $3.6 trillion). If you look again at the Fed's balance sheet, the total value of assets has increased by $3.6 trillion since the financial crisis until the end of 2014 when the US central bank finished its program. Furthermore, if the QE effect was actually -3%  decrease in the short term rate it turns out that the Fed has actually cut the rates by 8.25% between 2007 and mid-2015.

The last thing to consider around QE is the law of diminishing returns. Goldman Sachs estimated that during the first QE program 1$ trillion of asset purchases was an equivalent of 1.20% decrease of Treasury Bonds yields, in terms of QE2 the effect diminished to 1.00%, while QE3 was below 1.00%. For now, however, this assumption will not be considered so take it only as a curiosity.


THE FED BALANCE SHEET DURING THE NEXT RECESSION

In this paragraph I will consider two scenarios of possible US central bank actions, completely ignoring the forward guidance as well as a next optional tool called treasury yields capping (which is also related to buying treasuries). As we've already learned, the Fed Funds Rate (US interest rate) stands at 1.75% and there is a high probability that the policymakers won't go negative in the next downturn. Let's assume then two different sequences of events:

1. The Fed has to cut rates by 5.50% during a recession like it has previously been the case.

In this assumption, Jerome Powell with his colleagues first cut rates to 0.00% and then has to print an equivalent of 3.75% (15 rate cuts). Disregarding the law of diminishing returns it will be 15*$300 billion = $4.5 trillion.


Having said that, the Fed's balance sheet would explode to more than $8.6 trillion.

2. The Fed has to cut rates by 8.25% like they did between 2007 and mid-2015 including QE purchases.

After cutting rates to zero, there is still 6.50% more to go or 26 rate cuts of 0.25%. Again, ignoring the law of diminishing returns that would lead to $7.8 trillion more dollars out of thin air. In this scenario, however, it may take more time to materialize.


As a result, the total value of assets would reach astronomic $12 trillion. Can you even imagine?
To put things into perspective, the US size of the economy is $21,43 trillion in terms of Gross Domestic Product (GDP). Therefore, the ratio of the Fed's balance sheet to GDP would be 56%. In the first scenario, that number would reach 40%.

We all know, however, that the economy is not stagnant. Let's then assume that it would grow 2% each year (including a period of a recession) and the aforementioned scenarios would materialize until 2025. Under this assumption, the US GDP would be $23,66 trillion in five years. Thus, the total value of assets to GDP under each scenario would be 36% and 51% respectively. Currently, the Fed's balance sheet accounts for more than 19% of GDP. If you think that more than 50% is impossible, look at the European Central Bank (ECB - purple) and Bank of Japan (BOJ - white) ratios.

source: Holger Zschaepitz, Twitter

The ECB's total asset to GDP ratio is more than 40%, the BoJ's almost 103%. While looking at this chart, those scenarios seem to be more realistic. Yet, that's not everything. If the Fed would try to expand its Balance Sheet in that very aggressive way, it would lead to other implications that have to be considered.


IS THE FED GOING TO BUY STOCKS?

If the US Central Bank would have to increase its balance sheet to $8.6 trillion or $12 trillion it would probably have to also contemplate purchasing other assets than US Treasuries and Mortgage-Backed Securities (MBSs). Simply because of the size of the bond market. Currently, the US Bond Market Capitalization is roughly $41 trillion, including $14 trillion of US Treasuries and $9.2$ trillion of mortgage-related bonds such as MBSs. A significant portion of those is held by the Fed, which is shown on the chart below.


$2.44 trillion of Treasuries (gray) and $1.4 trillion of MBSs (light green) are currently held by the Federal Reserve, 17.4% and 15.2% of the entire issued pool of each class, or 17% altogether.

If the balance sheet would expand to $8.6 trillion (scenario 1) or $12 trillion (scenario 2). Then the entire share of holdings would jump to 37% and 52% respectively.

$14 trillion (Total value of US Treasuries) + $9.2 trillion (Total Value of all MBSs) = $23.2 trillion
Scenario 1: $8.6 trillion/23.2 trillion = 37%
Scenario 2: $12 trillion/23.2 trillion = 52%

For comparison, the Bank of Japan holds 51% of all Japanese Government Bonds. They also own 80% of its Exchanged Traded Funds (ETFs - passive funds traded like stocks) market. And here we get tot he crux of the matter.

As Reuters reported in September 2016, the Fed Chair on that time, Janet Yellen said:

“It could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions,” she said, adding that buying equities and corporate bonds could have costs and benefits.

It means only one thing, she has considered buying stocks and corporate bonds to combat the next economic downturn. Yet, this is nothing new, during the Great Financial Crisis, that idea was also on the table but fortunately, it was firmly rejected. Also, this activity is prohibited by the Federal Reserve Act. Sadly, in case of an economic downturn, it will probably be quickly amended. Moreover, as my above analysis shows, if the Fed still wants to push on a string it will have no other choice than buying those assets, otherwise, it will become the major player on the government bond market funding the US Government spending by creating money out of a thin air. There is also another option, government, and central banks' coordination. This, however, may undermine the central bank's independence (a topic for another article).


SUMMARY

It doesn't sound promising that when the next recession finally arrives the Fed's balance sheet may eventually reach from $8.6 trillion to $12 trillion, and this is all using conservative estimates. The biggest problem, however, is that it would even further distort already broken financial markets. Investors, such as in the case of Japan will be crowded out of bonds and will be forced to buy different assets, such as equities, REITs (Real Estate Investment Trusts), or corporate bonds. In that sort of environment, those who will hold financial assets will record enormous gains. Thus, the rich will get even richer once again. I also wonder what would happen to pension funds as the effect of artificially suppressed bond yields, many of them are already underfunded. Keep in mind that in the United States, there are 76 million baby boomers with an average age of 65 (as of 2019). I am clutching my head in disbelief when I am writing this and I hope that this maths will never work.

Furthermore, it has to be reminded that policymakers' significant market interference has been also the reason for price discovery disappearance (a process of determining a proper price through the interaction of buyers and sellers) over the last decades. Their utter desperate activities cannot be called differently than manipulation. Will they go further? As you can see, highly likely. Will this be effective? Probably less and less with each attempt.

Final word. My analysis shows that the most powerful central bank in the world, the Fed is lacking policy tools, while the European Central Bank and Bank of Japan have already fired all their bullets. So, if there is no major central bank on the globe who has the ability to effectively combat a recession, maybe it's the time for them to go?

Best Regards,

Seb

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