‘Decade of the central bank’ ends as the Fed shifts to ‘new paradigm’

'Decade of the central bank' ends as the Fed shifts to 'new paradigm'

On Nov. 25, 2008, the Federal Reserve launched the shot heard around the financial world.

The U.S. central bank announced it would start using digitally created money to buy mortgage debt in an effort to drive down interest rates and resuscitate a dead housing market.

Along with a series of cuts that ultimately would take short-term interest rates close to zero, the move was part of an ambitious gambit to take the country out of its worst economic crisis since the Great Depression. It quickly expanded to the purchase of government bonds in a total of three rounds that spanned six years.

Flash forward 11 years later.

The Fed’s campaign of “quantitative easing,” along with keeping rates historically low, coincided with the longest expansion and most robust Wall Street bull market in U.S. history. Coming at a time of prolonged gridlock in Washington, the Fed’s monetary policy moves thrust it front and center as the sole provider of stimulus.

“It was the decade of the central bank,” said Quincy Krosby, chief market strategist at Prudential Financial. “Stimulus was wanting, and the burden fell on the central banks to normalize the environment.”

Economists can and will debate the effectiveness and the long-term consequences of all the extraordinary moves, but there can be little doubt that in the past decade, the epicenter of economic management was at the Fed, along with its sister central banks around the globe.

No collective entity had greater influence for the past 10 years over the economy and financial markets.

‘The extraordinary has become ordinary’

While the desire may have been a normalization of a global economy that had been crushed by a speculative real estate bubble, the measures taken to achieve that goal were anything but normal.

Central banks cut borrowing rates more than 50 times over the past decade and instituted “money printing” QE programs to the tune of nearly $11 trillion just between the Fed, the European Central Bank and the Bank of Japan. Never before had these institutions been called upon by so many to do so much. But lacking other fiscal measures — government spending on capital projects and the like — there was little alternative.

Former Fed Chairman Ben Bernanke even half-joked once that such programs don’t work in theory but do in practice, part of the general reluctance central bankers had to such aggressive intervention. His successor, Janet Yellen, put a halt to the money printing and began the process of gingerly rolling off the bond portfolio acquired through the three rounds, and these days continues to defend the Fed’s stimulus actions during and after the financial crisis.

“After all, the economic consequences of what we had were really quite terrible,” Yellen said recently at a World Business Forum conference in New York. “This was a very serious thing, but it could have been the Great Depression. My colleagues and I knew that it was on us to figure out what we needed to do to make this the Great Recession rather than the Great Depression.”

Federal Reserve chair Janet Yellen (L to R) and former Federal Reserve chairs Ben Bernanke and Paul Volcker appear together for the first time in New York, April 7, 2016. The panel is geared toward millennials and focused on decision-making with international implications.

Kathy Willens | Pool | Reuters

Since the Fed took those unprecedented steps, financial markets have grown accustomed to a world where “Don’t fight the Fed” has morphed from being a stale Wall Street aphorism to a blood oath between investors and central bankers.

“What was once extraordinary has become ordinary, not just in the United States but all over the world,” Krosby said.

Indeed, it wasn’t just the Fed busy pumping up the economy with monetary largess.

The European Central Bank’s Mario Draghi, who served as ECB chairman from 2011-19, famously promised a “whatever it takes” approach in 2012. The landmark speech signaled a massively aggressive stimulus that eventually expanded the bank’s balance sheet by about $2.5 trillion in U.S. dollars.

Mario Draghi, president of the European Central Bank.

Getty Images

The real pioneer of QE, though, was the Bank of Japan, which has practiced expansionary monetary policy for decades, though to less clear results. The BOJ has exploded its holdings by some $4.5 trillion over the years, only to experience minimal growth that included the “lost decade” of the 1990s.

In the U.S., the asset purchases amounted to about $3.7 trillion, taking the Fed balance sheet at one point past $4.5 trillion.

When all was said and done, the three banks, along with dozens of others around the world, became the stewards of a wobbly global economy.

“The central banks were sucked into a world they never wanted to be in,” said Ethan Harris, head of global economic research at Bank of America Merrill Lynch. “Then, central banks figured out this is the new world we’re in and we have to find new tools to promote growth. They went from reluctant participants in international policy to eagerly embracing it.”

Markets gladly went along for the ride.

The S&P 500 has risen more than 380% off the March 2009 lows, and corporate and household debt both have exploded higher in nominal terms, providing some concern over loose Fed policy giving rise to another asset bubble.

Still, those worries for now are gaining little traction.

After all, the stock market is trading at 17.8 times forward earnings, certainly more expensive than the 10-year average of 14.9 but by longer-term historical norms not out of bounds.

Nonfinancial corporate debt has surged to $6.6 trillion, approaching double where it was during the crisis. But as a percentage of market capitalization, it’s actually just 32.9%, or not terribly far from the all-time low of 27.6% in 2000 and well below the peak of 102.4% in early 1982, according to Fed data.

At the household level, total debt has climbed to nearly $14 trillion, past its $12.7 trillion recession peak. However, as a measure of household income, debt service has fallen to 9.7%, the lowest ever in data going back to 1980.

Little room to move

As the decade ended, the institutions found themselves in quite a different position from where they started, particularly considering the worries over the state of the economy and potential asset bubbles.

Where they once had plenty of space to offer policy accommodation in the case of a downturn, central banks now face severe restrictions. Policy rates among G-7 countries all are below 2% and countries that practiced QE face bloated balance sheets that threaten to pose financial imbalances.

The U.S. Fed tried reducing its bond holdings over the past two years but had to retreat after bank reserves fell and overnight borrowing rates briefly surged. The Fed now is back in expansionary mode, though officials insist that the new Treasury note-buying is not the same as the old QE, which focused on longer-duration government debt.

“This is a new paradigm. This is the world central banks are going to have to operate in where zero percent policy rates are more the norm,” said Tom Garretson, fixed income strategist at RBC Wealth Management. “For the Fed, it’s figuring out which are the tools and how to implement them.”

They’ll be picking from a sparse toolkit, with their imaginations and the market’s willingness to tolerate still more financial tinkering as both allies and obstacles.

“The problem is all the other major central banks have very low ammunition. Even if they wanted to be super-interventionist, they don’t really have the tools,” Harris added. “The Fed doesn’t have enough ammunition to deal with a future recession. The BOJ and ECB can’t even deal with a moderate shock.”

The fight for independence

Harris predicts that fiscal policy in the form of higher spending and investment will be needed to deal with the next crisis. But the warring parties and their intractable differences have made passing spending such measures difficult in the current climate.

For their part, Fed officials have been conducting a number of public hearings and have been holding internal discussions about what to do next time they’re called to spring into action. The central bank’s policymaking arm, the Federal Open Market Committee, has indicated that it is on hold indefinitely if the economy stays on its current growth course.

Consensus for now is that the Fed likely again would go down to zero rates quickly and inform the public that it will keep rates low for a prolonged period, a strategy known as “forward guidance.”

“We’re going into a very different period of Federal Reserve policy than we’ve experienced since 2012. I think what they are going to be putting into play is a more aggressive form of forward guidance,” said Joseph Brusuelas, chief economist at RSM. “We’re in a transition period from the central banks being the only game in town. It’s a tacit acknowledgement [from the Fed] that we’ve reached the end of our unorthodox policies, we may only be effective at the margins, and that it’s really time for the fiscal authorities going into the next decade.”

That’s a supposedly cooperative relationship that’s been under considerable strain, at least in the U.S.

President Donald Trump has repeatedly criticized the Fed and Chairman Jerome Powell for not continuing to supply monetary juice. The president has demanded the Fed cut rates to zero and implement more QE to provide cover in the U.S. tariff battle with China.

President Donald Trump (R) introduces his nominee for the chairman of the Federal Reserve Jerome Powell during a press event in the Rose Garden at the White House, November 2, 2017 in Washington, DC.

Drew Angerer | Getty Images

So in addition to navigating its way through the economy, the Fed also has to continue to prove it is independent from outside pressure, be it political or economic.

In the decade ahead, the Fed will have to wrestle with questions about the usefulness of negative interest rates, with $11.5 trillion worth of global sovereign debt still carrying negative yields.

At the same time, there has been a rising drumbeat about Modern Monetary Theory — the belief that governments can run up debt to pay for social programs which the Fed can underwrite with low rates so long as inflation stays in check. Harris calls the belief “the free lunch theory of monetary policy.”

“These Fed officials are very focused on what history is going to say about them. They want to be in the same pantheon as [former Fed Chairman] Paul Volcker,” Harris said. “They want to be known as the people who defended the independence of the bank.”

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