While in recent weeks there has been a material increase in Fed balance sheet normalization chatter, according to a new report from Deutsche Bank analysts, it may all be for nothing for one simple reason: should the US encounter a recession in the next several years, the most likely reaction by the Fed would be another $1 trillion in QE, delaying indefinitely any expectations for a return to a “normal” balance sheet.
As a reminder, as of this month, the duration of the latest expansionary cycle – as defined by the NBER – has reached 93 months, surpassing the 92 months of the 1982-1990 cycle, and is now the third longest in history. Should the cycle persist for another 27 months, or just under two and a half years, it would be the longest period of “economic growth” in history.
That observation has prompted speculation that at some point in the next several years, the US economy will finally succumb to what historically has been a contraction in output, aka a recession. The question, then, is how would the Fed responds. The answer, according to a Deutsche Bank analysis of the future shape of the Fed’s balance sheet, is with another a $1 trillion liquidity injection, which would stop dead in its tracks any plans for a Fed balance sheet renormalization.
As the DB’s Matthew Luzzetti writes in his analysis, to this point, the economic backdrop considered is relatively optimistic: the economy is assumed to not enter a recession over the next eight years and the Fed is able to normalize the fed funds rate in line with their expectations. However, given that the current expansion is already well advanced, it is possible that the economy enters a recession before the Fed’s balance sheet normalizes.
Prospects for normalizing the balance sheet would be dramatically altered by a recession, potentially even a mild one. This is because with the fed funds rate still relatively close to zero, and the neutral fed funds rate potentially remaining low over the coming years, the Fed may not be able to provide enough accommodation by only cutting its policy rate. Just as in the aftermath of the financial crisis, the Fed may have to turn to another round of QE to support the economy during the next recession.
How would a recession affect the Fed’s ability to normalize its balance sheet? DB explains:
We use recent analysis by the Fed Board staff to calibrate the Fed’s reaction function to a recession in the next several years. This work considered how the Fed would respond to a severe recession, similar in magnitude to the financial crisis with the unemployment gap rising 5 percentage points, and with the fed funds rate already at 3%. Using the Fed’s model of the US economy, FRB/US, this work concluded that the fed funds rate should be cut significantly below zero to provide enough accommodation to the economy in response to the recession. With the actual fed funds rate constrained by the zero lower bound, the paper finds that the Fed could provide similar accommodation by a combination of another QE program and strong forward guidance about the future path of the fed funds rate. The size of the required QE package is significant: $2tn.
In some ways this scenario seems too pessimistic. The magnitude of the downturn considered is likely to be more severe than the next recession for several reasons: (1) they consider a recession in line with the financial crisis, (2) there is limited evidence of substantial imbalances or overheating in the economy which should limit the depth of the next recession, and (3) monetary policy is still accommodative. Instead, a milder recession appears more likely. Conversely, it may be optimistic to assume that the fed funds rate is able to reach 3% before the next recession occurs, suggesting that the Fed could have less scope to ease monetary policy by cutting rates and therefore may have to resort to a larger QE program.
We consider an alternative scenario in which the economy enters a more mild recession in 2020 as the Fed has raised the fed funds rate to just above 3%. We assume that the recession causes the unemployment rate to rise 2.5 percentage points.
Please follow SGT Report on Twitter & help share the message.