In December, Janet Yellen hiked right into what might as well be a recession in what Marc Faber suggests will go down as one the most ill-timed policy maneuvers in the history of central banking.
Things didn’t fall apart immediately, but the situation started to deteriorate markedly at the beginning of last month when collapsing crude prices and a bungled attempt to implement a circuit breaker in China triggered harrowing bouts of volatility across markets and set investors up for one of the most inauspicious starts to a year in history.
Now, with policy divergence between the Fed and its DM counterparts set to support the dollar at the expense of both EM stability and US corporate profits and with the continual weakness in crude set to trigger a default cycle, the FOMC faces a rather vexing question: “is it better to admit to a policy mistake and reverse course at the risk of destroying credibility or is it preferable to cling to the narrative so as not to completely destroy the notion that all is well and the US recovery is on track?”
“Fed officials continue to signal rate increases for later this year, but financial markets are increasingly focused on the risk of a policy reversal,” Goldman writes, in a new note. “At one point last week, markets saw a higher probability of a cut than a hike at the June FOMC meeting.”
With the market thus skeptical about the Fed’s willingness and/or ability to cling to the tightening cycle, Goldman has taken a look at the history of policy reversals, which the Vampire Squid reminds you are not “inherently” bad.
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From Goldman
There is nothing inherently wrong with policy reversals. If the growth or inflation outlook were to deteriorate meaningfully, optimal policy might call for a lower funds rate, even shortly after an increase. In Exhibit 2, for example, we show the implied cumulative probability of a cut using the Fed’s large-scale macroeconomic model, FRB/US. In this exercise, we use the median forecast from the FOMC’s Summary of Economic Projections (SEP) as the baseline for the simulations, and then allow FRB/US to draw shocks that are calibrated to the economy’s realized uncertainty over the last twenty years. We then calculate the path of the funds rate in each simulation using Chair Yellen’s preferred version of the Taylor rule, the economic outcomes from the simulations, and an assumption that the neutral rate either remains flat at zero or normalizes gradually at the rate implied by the FOMC’s “dot plot”.
Under the assumption that the neutral rate remains flat, the cumulative probability that the policy rule calls for a cut is about 14% by 2016Q4 and 27% by 2017Q4. If we instead assume that the neutral rate gradually normalizes, then the probability of returning to zero is 11% by 2016Q4 and 18% by 2017Q4. Thus, it is certainly not out of the question that the FOMC could reverse course—even over the near-term—given a large enough shock to the economy.
However, history suggests this type of analysis might miss something important about central bank behavior. In particular, policy reversals—lowering rates shortly after an increase, or raising rates shortly after a cut—are surprisingly uncommon in the data. According to one estimate, they would occur about four times more often than we observe if policy were responding optimally to all new shocks.
To demonstrate this point, we collected quarterly data on policy interest rates (or near equivalents) for G10 economies from roughly 1990 to the present. We then divided all the observations into rate hiking cycles and rate easing cycles, where the cycles include any quarters with no changes in interest rates between hikes/cuts or immediately after. We then defined a “reversal” as a cycle lasting only one or two quarters. Under this construction, if the Federal Reserve reduced rates in the first half of this year it would count as a reversal; if the Fed cut rates in the second half or beyond it would not count as a reversal. This methodology will of course miss any reversals that occur within a single quarter—which have happened on a few occasions (including around the 1987 stock market crash and the September 2001 terrorist attacks). An example of this identification scheme for the Euro area is shown in Exhibit 3.
Exhibits 4 and 5 provide some summary statistics. Of the 85 cycles in our dataset, the average lasted about nine quarters (including the periods after rate changes where policy was on hold). The distribution of rate hiking cycles is more concentrated; that for easing cycles has a long right tail, with five examples lasting more than five years.
As is well known, monetary policy changes tend to be highly persistent. In our dataset, the policy action in any one quarter (hike, cut, or hold) matches the action in the previous quarter 64% of the time, and the simple autocorrelation coefficient of quarterly policy rate changes is 0.37. Policy reversals, as defined above, are rare: we count only one “cut reversal” (Sweden, 2001) and four “hike reversals” in the entire sample—for a total of 6% of the observations.
The US had no hike reversals as we have defined them here. The Eurozone and Japan both had one each: the BOJ’s hike in August 2000, followed by a cut in February 2001; and the ECB’s hike in July 2011, followed by a cut in November 2011. In both cases the reversals occurred alongside sharp downgrades to consensus growth expectations.
Additionally, since mid-2009, six G10 central banks have raised policy rates only to change direction later (one of them, New Zealand, did it twice). Under our definition of policy reversals, only one of these examples (the mid-2011 hike from the ECB), would qualify. The causes behind the other rate cuts were varied. In most cases, consensus forecasts for growth and inflation did not actually deteriorate much around the time of the first rate cut; policy statements indicate that overvalued exchange rates likely played a role in some cases.
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In other words, the record shows that central bankers are either very stubborn or very concerned that admitting to their own mistakes would be diastrous for markets.
It's also interesting to note that in the post-crisis years, officials seem to be increasingly concerned with the relative strength of their currencies even when inflation and growth forecasts are stable, a reflection of the extent to which the global currency wars have everyone on edge.
But the most distrubing thing of all is that according to Goldman, policy makers are inclined to deliberately underdeliver when it comes to reversals for "communication- and credibility-related reasons."
"The second reason for the lack of policy reversals may be central banks’ preference for 'gradualism'—the tendency to adjust policy only partially toward warranted levels at each meeting (this can also be referred to as “interest rate smoothing”)," Goldman says. "For example, if a change in the inflation outlook calls for the funds rate to be 75 basis points (bp) lower, the FOMC might move in three 25bp steps, rather than all at once."
So central bankers are more than happy to go overboard when working in proactive mode but when it comes to being reactive, they're likely to stop short of doing what the data calls for in order to save face. Perfect. What could go wrong?