It takes more than the Fed
25 April 2017
Now that the US Federal Reserve (Fed) is indicating a preference for beginning to reduce the size of its balance sheet by the end of the year, the expectation among most economists is that this process will put upward pressure on global long-term interest rates. Prima facie support for this view comes from the fact that term premia – the compensation investors require to hold long-term nominal interest rate risk – in the core government bond markets have on average been much lower in the post-crisis era of central bank asset purchase programmes (APPs) than in the pre-crisis era of conventional monetary policy. Support also comes from more rigorous empirical studies, though estimates of the impact of an APP equivalent to 10% of GDP range vary widely; from 23-175bps in the US, 27-64bps in the Eurozone, 34-107bps in the UK and 10-26bps in Japan. Studies have also tended to find that in the US at least, earlier APPs had larger effects than later ones and that the signalling effect (about future policy rates) on yields has been at least as important as the effects of portfolio rebalancing (see Table 1).
There are other reasons to be cautious about the impact of Fed balance sheet normalisation. One is that the Fed is likely to phase out reinvesting maturing bonds in the first instance and avoid ever selling securities outright. Another is that the aggregate APPS of central banks have a larger impact on global yields than Fed purchases alone – and we expect both the European Central Bank and Bank of Japan to buy bonds until at least the end of 2018. There is also evidence that when central banks wind down their APPs prematurely it tends to depress yields by weighing on growth and inflation expectations. Meanwhile, non-monetary factors are also holding down global interest rates. These include the high global debt levels; excess of desired savings over investment and low potential growth that are keeping equilibrium real interest rates very low; persistently low underlying inflation; regulations incentivising financial institutions to hold more duration assets than they did in the past; and on-going de-risking by defined benefit pension funds. So while some modest increase in global yields is likely if the Fed starts running its balance sheet down, yields are very unlikely to return to their pre-crisis levels.