IN BRIEF

  • In the aftermath of the first Federal Reserve (Fed) rate hike in nearly a decade, attention has briskly shifted to the future. What’s next for policy interest rates? How will central banks deal with their extraordinarily large balance sheets? In this paper, we take an even longer view. What does developed market monetary policy look like in future cycles, and what does it imply for markets?

  • Even as central banks experiment with mildly negative interest rates, we believe that balance sheet policies similar to quantitative easing will remain a regular feature of the landscape. Born of necessity when policy rates hit their zero lower bound, quantitative easing emerged to repair markets and ease financial conditions.

  • The process of experimentation with “unconventional” policy will continue so long as central banks face the limit of a lower bound on policy rates. One idea that has gained traction is the direct monetization of fiscal stimulus by central banks (i.e., helicopter money). Such policies need to balance the exigency of economic stimulus with the inherent risks, but it is fair to say that they are less unconventional now than they used to be.

  • More active balance sheet policy and muted variation in policy rates imply that yield curve steepening and flattening in subsequent cycles will be more moderate. The inversion of the curve that historically preceded recessions may not arise and, if it does, may not send the same signal in future cycles.

  • All of these developments are a mixed blessing for multi-asset investors. On one hand, central banks are finding ever more diverse and creative solutions to achieve their mandates. On the other, it suggests that the warning bell coming from the yield curve will be less informative than it used to be about the most worrisome of risk-off outcomes—when the economy tilts into recession. In our view, variations in quantitative easing among central banks will define the degree of monetary policy divergence in the coming years.
 

When central bankers ratcheted down overnight interest rates to zero in 2008-09, they plunged into uncharted waters by impairing the mainstay of their inflation and output stabilization policies. In response to that challenge, policymakers assembled a broader tool kit of instruments to tackle an even wider set of objectives. Today, central banks at the vanguard of developed market (DM) business cycles are beginning a slow move toward the exit of “unconventional” policies, while those further back in their cycles continue to seek ways to add monetary stimulus. Against this backdrop, we contemplate what these innovations will mean for the implementation of monetary policy in the future and the implications for the “normal” behavior of financial markets over the business cycle.

Equilibrium interest rates—those prevailing when an economy is operating at its potential and inflation meets the central bank target—have been on a steady decline in DM economies, a decline that should persist well into the future as demographic headwinds and slower trend GDP growth weigh on yields. As a result, drawing policy rates down to zero and deploying quantitative easing (QE) will become a far more frequent occurrence. We argue that since QE acts more directly than policy rates to suppress long-term yields, we expect its more frequent use to temper yield curve dynamics in future cycles. The steepening during periods of economic weakness and flattening during recoveries will likely become more muted. The low levels of fixed income volatility that arose from central banks “leaning” on the yield curve should also repeat themselves in future cycles.

The transition from here to there will be one in which central bank balance sheets shrink from currently elevated crisis-era levels

Hence, the future of monetary policy looks to be one with generally larger central bank balance sheets, a multiplicity of policy instruments and milder yield curve fluctuations over the course of the business cycle. In all likelihood, the transition from here to there will be one in which central bank balance sheets shrink from currently elevated crisis-era levels. That process is underscored by the extent of policy divergence among QE-wielding central banks and the large attendant moves in foreign exchange markets. The appreciation of the dollar from mid-2014 through 2015 is the most pronounced case in point. The transition may also be fraught to the extent that winding down central bank balance sheets and falling emerging market currency reserves coincide, which may ultimately put additional downward pressure on DM bond prices.

To be clear, the direction of causality that we highlight in this work runs from economic outcomes to deployment of unconventional policy and to changes in yield curve dynamics. Yield curve dynamics are thus symptom, rather than cause, of policy efficacy; we build on the panoply of research that has demonstrated the efficacy of QE in the wake of the global financial crisis (GFC). But the future of policy will be different in its application from the past, as monetary policy becomes more targeted at parts of the economy that anchor on longer dated interest rates and central banks experiment with alternative approaches to the zero lower bound (ZLB) on nominal policy rates.

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