By adjusting the policy rate (the federal funds rate), the Fed alters financial conditions, which then influences the behavior of businesses and households. These changes impact a variety of decisions, including how much to consume, produce, and invest.
In December of 2008, after reducing interest rates over an ~18 month period, the Federal Reserve hit the zero bound. They decreased the federal funds rate to the 0 to 1/4 percent range where it currently sits. In response to the zero bound being hit, exotic, never before seen forms of stimulus were put into play.
When short-term rates could not be reduced any further, the Fed implemented additional measures to suppress longer-term rates, which have not hit the zero bound. Specifically, the two main approaches that have been used are quantitative easing (QE) and forward guidance. The implementation of these new forms of monetary policy have made it difficult to compare pre-recession monetary policy with post-recession policy.
As a result, a number of researchers have been attempting to create what are known as "shadow rate" models to quantify the current stance of monetary policy. In a shadow rate model, mathematics are used to equate exotic forms of stimulus to an equivalent federal funds rate that is not bounded at zero percent. One model that has been receiving significant attention has been put forth by Jing Cynthia Wu and Fan Dora Xia. The chart below shows the Wu-Xia Shadow Federal Funds Rate.
The blue line is the actual federal funds rate, the green line shows an approximation of what the federal funds rate would be if the current level of monetary thrust had been achieved through short-term rates instead of quantitative easing and forward guidance. Looking at the shadow rate allows us to see a rough comparison between monetary policy conditions prior to the recession, during the recession, and where we sit currently. As you can see, current monetary conditions are equivalent to an environment with a federal funds rate near negative 3%.
This brings up an alarming question. If the US suffered another financial shock, what response could the Fed muster at this point? When things began to collapse in 2007, the federal funds rate was above 5%. The course of the recession has taken that down to an effective rate near -3%. If something happened to the economy now, it's possible the Fed would be quite literally out of ammunition. It's as though we're skydiving without a reserve chute — any problems with the current support mechanisms and we could be in free fall.
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I say this not to scare you but to provide a window into the Fed thought process. Policymakers are well aware of this situation (the chart above was pulled from the Atlanta Fed website), and the precarious environment we are in. I believe this is partly the impetus for ending quantitative easing, and demonstrates why the Fed may be interested in raising rates sooner rather than later.
Of note, today the minutes of the last FOMC meeting were released and show that Fed officials have agreed to end quantitative easing by October. How did the market respond to the assignment of an end date? Stock indexes rose to their session highs.
Ever since beginning to write for Dow Theory Letters, I've claimed that quantitative easing has been misunderstood by most market participants. Few took the time to understand the intricacies of what QE actually entailed and instead relied on superficial takeaways like, "The Fed's injecting billions of dollars into the economy." If you never understood how QE worked, then I don't blame you for wondering how the markets could ever live without it and assuming the market would crash upon its withdrawal. However, if you took the time to digest my comments on this topic, then you probably understand what the rest of the market has come to understand: QE did not have nearly as much of an effect as most thought, due to the indirect way in which it operates.
I for one am relieved to see that QE is on its way out. While the Fed will still have a large balance sheet to manage, ending QE means one less distortion in the markets to navigate.
The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
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