The Fed (and every other Fed commentator) uses the word “normalization” to describe the upcoming next phase of monetary policy. While the debate focuses on when that might be — as in, exactly how long is a “considerable period?” — we’ll simply say sooner than the markets expect. Now we can answer this question recently posed to me by a financial advisor: “What does normal mean?” “Normalization” refers to the two main components of the policy response to the 2008 financial crisis: quantitative easing (QE) and zero interest rate policy (ZIRP).
By “normalization” the Fed means returning its balance sheet to its pre-crisis size by exiting quantitative easing. That was last year’s story (the “taper tantrum”), and in the September Federal Open Market Committee meeting the Fed outlined its plans for how it intends to normalize its balance sheet. Leaving aside the many “inside baseball” details, the key implication of QE was that this policy was fundamentally directed towards reducing longer maturity interest rates. The Fed supported the housing recovery by targeting the QE programs at subsidizing mortgage borrowing costs. Hence, the exit from QE debated last year led to increases mainly in longer maturity interest rates.
“Normalization” means the end of ZIRP. This second part is more “normal” in that we can compare policy rates historically over past periods of Fed policy accommodation. Importantly, when considering the degree of policy accommodation historically, we need to look at the “real” fed funds rate (the nominal fed funds rate less the rate of inflation). Today, with inflation around 2%, current policy places rates at minus 2%.
We highlight a few key observations. First, policy accommodation following recent recessions has become more and more accommodative. The low point of accommodation in the mid ‘90s was around 0% in real terms, and in the early 2000s was around minus 50 basis points, or 0.5%. But the post-2008 period has seen the most persistently negative policy rates since those resulting from the inflation of the 1970s. What is less evident when looking at a chart of “real” policy rates is how extraordinary this period is for both its length (going on seven years) and for being at zero nominal rates. Both of these create a stronger “reach for yield” response from investors, suggesting a future market response to “normalization” that may be different than that observed historically.
From “Highly” to “Merely”
The Fed considers its monetary policy “highly” accommodative. Historically speaking, that is an understatement. Merely “accommodative” policy viewed from this historical perspective meant a zero real fed funds rate, “neutral” meant a 1-2% real rate, while “tight” policy meant a 2-4% real rate. “Highly” accommodative meant anything negative in real terms. Hence, moving from “highly” to “merely” accommodative implies a move in nominal fed funds rates from zero to 2%.
History is not kind when it comes to the Fed’s track record of exiting policy accommodation. And our concerns are heightened by a sense of complacency in bond markets that underprice such a move back to more “normal” fed funds rates. Our biggest concern is around areas of the fixed income markets most exposed to where the exit from ZIRP will have the biggest impact: shorter maturity yields.
by Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income.
Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.
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