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The normalization of US monetary policy: risks and challenges
William De Vijlder
For many months the prospect of the start of the normalization of US monetary policy has given rise to
considerable concerns at the heart of which are three questions: what is the risk of a policy error? What is
the risk of a policy surprise? What is the risk of an endogenous disruptive market reaction to a policy
stance? The challenge for the Federal Reserve is huge if only because of the asymmetry in case of a policy
mistake and the possibility of big reallocations of investment portfolios and global spillovers that could
backfire on the US economy.
At the end of its two-day meeting on 16 December 2015,
the Federal Reserve Open Market Committee, which is
tasked with setting US monetary policy, decided to
increase the federal funds rate by 25 basis points,
bringing the target range for the effective federal funds
rate to 0.25-0.501 and taking the first step in the process
of monetary policy normalization2. The previous rate
hike took place on 28-29 June 2006, and the first hike of
the previous tightening cycle happened on 29-30 June
2004. The time span that has elapsed since the
previous tightenings and the fact that since November
2008 the effective federal funds rate has basically been
at the zero lower bound3, remind us of how atypical the
monetary environment has been in recent years.
Inevitably, the prospect of rising policy rates has caused
considerable concern as we were getting closer to the
start of a new tightening cycle. Today, about two months
after the December hike, these concerns have not gone
away, quite to the contrary. They are related to the
market turmoil in recent weeks, the weakness of certain
economic indicators in the US, in particular as far as the
manufacturing sector is concerned, the stress in several
developing economies, the weakness of commodity
prices, the strengthening of the effective exchange rate
of the dollar, the widening of credit spreads, etc. Some
of these developments are related to the slowly
changing monetary environment in the US. Others are
driven by external factors (e. g. the growth slowdown in
China) although they may influence the stance adopted
by the Federal Reserve. At the heart of these concerns
are three questions: what is the risk of a policy error?
What is the risk of a policy surprise? What is the risk of
an endogenous disruptive market reaction to a policy
stance that is appropriate when judged by the economic
fundamentals and well communicated? The conclusion
of this article is that the challenge for the Federal
Reserve is huge, if only because of the asymmetry in
case of a policy mistake. A premature tightening could
cause a growth slowdown that would be hard to stop in
view of the fact that the policy rate is still so close to
zero and that another round of quantitative easing might
be less effective than before. Too late a tightening, on
the other hand, could see a bond market sell-off on the
back of rising inflation, causing a decline in the stock
market and a widening of corporate bond spreads and
having a negative impact on growth. Another reason
why the challenges and risks are huge is that years of a
very expansionary monetary policy have forced
investors to “climb the risk ladder” and invest more in
riskier assets, thereby counting on higher returns.
Higher policy rates could cause a rise in risk aversion,
and the ensuing portfolio adjustments would ultimately
have an impact on the real economy. Finally, the
international spillovers of monetary tightening should
also be taken into consideration if only because they
may backfire for the US economy via international trade
and the evolution of the dollar4.
An atypical monetary policy environment
During recessions, monetary policy is eased
considerably because, depending on the mandate of
the central bank, inflation eases, implying that there
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is no longer a need to keep interest rates at a high
level, and/or the decline in activity needs to be
stopped to make way for an economic recovery.
What made the recession of 2008-2009 special were
its depth and length; hence it is now called the Great
Recession. According to the Business Cycle Dating
Committee of the NBER, the peak of the business
cycle was reached in December 2007 and the trough
in June 2009, so the recession lasted 18 months.
This made it the longest since World War II. What
also made it special was the extent of policy reaction
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required, in particular in terms of monetary policy.
Table below provides an overview of the rate cut
cycle that started on 18 September 2007, i.e. well
before the recession began. Interestingly, after a
cumulative easing of 325 basis points, there was a
long pause after the 30 April 2008 meeting, and the
easing only resumed on 8 October 2008, a number of
weeks after the Lehman Brothers collapse. On
16 December 2008 the zero lower bound was
reached. Chart 1 compares this easing cycle with the
previous cycles in recent history.
FOMC decisions with respect to the target rate for Federal funds
Date
Level before the meeting (%)
18 September 2007
31 October 2007
11 December 2007
22 January 2008
30 January 2008
18 March 2008
30 April 2008
8 October 2008
29 October 2008
5.25
4.75
4.50
4.25
3.50
3.00
2.25
2.00
1.50
16 December 2008
1.00
Table
Comparison of Federal Reserve easing cycles
12
11
10
9
8
7
6
5
4
3
2
1
0
Start of the Easing cycle
Sep.1984
Oct. 1987
Jun. 1989
Jul. 1995
Jan. 2001
Sep. 2007
1
Chart 1
11
21
31
41
51 61 71 81 91 101
months
Sources: Federal Reserve, BNP Paribas
Change in basis points
-50
-25
-25
-75
-50
-75
-25
-50
-50
New target range established
of 0 to 0.25%
Source : Federal Reserve
In addition to cuts in the Federal funds rate and the
discount rate, other tools were deployed not only to
handle liquidity disruptions5 but also to ease policy
further to near or at the zero lower bound for the Federal
funds rate. QE1 ran from 5 December 2008 until
31 March 2010 (USD 1.25 trillion MBS purchases, USD
300 billion Treasury security purchases, USD 172 billion
agency debt security purchases) and QE2 from
12 November 2010 until 30 June 2011 (USD 600 billion
Treasury security purchases). Between 3 October 2011
and 30 December 2012, there was a maturity extension
program (“Operation Twist”) with USD 667 billion
Treasury security purchases and an equivalent amount
of sales (but with shorter maturity). Finally, QE3 started
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on 14 September 2012 and lasted until 31 October 2014
(USD 823 billion MBS purchases, USD 790 billion
Treasury security purchases)6. As a consequence, there
was a considerable increase in the Federal Reserve
balance sheet, both in the absolute amount and as a
percentage of nominal GDP (chart 2). The Wu and Xia
model (2014), using econometric techniques, “translates”
the monetary impact of the QE programs in a “shadow
Federal funds rate”, which by construction can be
negative. The advantage of this approach is that it
allows assessing the impact of a non-conventional
program by means of a traditional yardstick, i.e. the
policy rate. Chart 3 shows that the shadow Federal
funds rate went as low as -2.89%, a level reached in
August 20147. This illustrates how expansionary Fed
policy has been in this cycle.
The start of the current tightening cycle: too
late or too early?
Federal Reserve balance sheet in USD
and as a % of nominal GDP
US monetary policy cycle, real and nominal
GDP growth
270
240
210
180
150
120
90
60
30
0
% of nominal GDP
Billions of Dollars
5 000
4 500
4 000
3 500
3 000
2 500
2 000
1 500
1 000
500
0
03 04 05 06 07 08 09 10 11 12 13 14 15 16
Chart 2
Sources: Federal Reserve, BNP Paribas
Wu and Xia shadow Federal funds rate
6
5
4
3
2
1
0
-1
-2
-3
%
04 05
Chart 3
Effective federal funds rate, last
business day of month
Wu-Xia shadow federal funds rate,
last business day of month
06
07
08
09
10 11 12 13 14 15 16
Sources: FRBG, Wu & Xia (2015)
The vertical lines in chart 4 indicate the start of four
recent tightening cycles, whereas the shaded area
shows the difference between nominal and real GDP
growth, i.e. the change in the GDP deflator. The rate
hike cycle typically started when real GDP growth was
high and/or accelerating significantly and ended when
nominal GDP growth started to decline. Over an entire
business cycle, the tightening phase tends to be shorter
than the combined phases of policy easing and policy
rate stabilization at a low level. This illustrates the fact
that a monetary contraction serves to keep or bring
inflation under control, which tends to be a late cycle
phenomenon.
12
10
8
6
4
2
0
-2
-4
-6
Effective Federal Funds Rate*
Nominal GDP
(y/y, %)
Real GDP
(y/y, %)
*End of period
87 89 91 93 95 97 99 01 03 05 07 09 11 13 15
Chart 4
Sources: Thomson Reuters, BNP Paribas
While the historical experience is a reminder that a
monetary tightening cycle is an integral part of a
business cycle, it is also a source of concern: out of the
four most recent cycles, three were followed by a
recession and only the 1994 monetary contraction was
followed by continued growth. This result is striking in
view of how aggressive the rate hikes were in that year.
In addition in the current cycle, the depth of the
recession, the slowness of the recovery and the extent
of monetary expansion, to name just a few factors,
explain why the prospect of the mere start of a
tightening cycle already became a matter of concern
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quite some time ago. In assessing this concern, it is
useful to look at the 2-year Treasury note yield while
keeping in mind the fact that the yield level on a given
day will be dependent on the expected policy and shortterm interest rates over the subsequent two years. A
rising yield would then point towards an increasing
likelihood of one or more monetary tightening(s), and
the volatility of the daily change in yields can be
considered an indicator of market nervousness. As
shown in chart 5, volatility has been on a rising trend
since the start of 2014, suggesting that concerns about
a rate hike have been growing. One could even argue
that this started around the middle of 2013 on the
occasion of the “taper tantrum” 8.
US 2-year Treasury Note volatility
0.24
0,24
US 2-y Treasury Note, 20-day
standard deviation of daily change
0,21
0.21
0.18
0,18
0,15
0.15
0.12
0,12
0.09
0,09
0,06
0.06
0.03
0,03
0.00
0,00
08
Chart 5
09
10
11
12
13
14
15
16
Sources: CBOE, Thomson Reuters, BNP Paribas
Since the December hike, these concerns have not
gone away, quite to the contrary. Answering the
question of whether the timing was appropriate is
impossible to do at this stage in a definitive way. Not
enough time has passed, so a judgment would
inevitably be based on forecasts with respect to the
evolution of economic growth and inflation rather than
on outcomes9. The intensity of the debate about the
appropriateness of the decision reflects a combination of
factors. The first is that monetary policy and in particular
tightenings in the 21st century have a shorter lead time
over inflation than, for example, they did in the 1990s.
This implies that when a central bank tightens, investors
expect a pick-up in inflation quite soon afterwards. In the
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absence thereof, real interest rates would rise, the
economy could suffer and commentators would argue
that the central bank has made a mistake. In the ‘90s,
when the lead time was longer, Alan Greenspan, then
chairman of the Federal Reserve, used the metaphor
that the conduct of monetary policy was like bringing a
petroleum tanker back to port: the maneuver needs to
start miles in advance. This lead time has shortened,
possibly because financial markets play a bigger role in
the conduct of monetary policy in the sense that the
central bank factors in the likely market reaction to its
decisions10. This would imply that in case of concern
that a rate hike could be considered premature, the
central bank might refrain from proceeding in order to
avoid a negative market reaction that otherwise would
weigh on the economic outlook via wealth effects (in
case of a stock market or property market decline) or
the cost of funding (higher bond yields, including for
corporates). The longer the lead time, the bigger the risk
that a hike would indeed be perceived as premature
because the economic models used implicitly or
explicitly by “the market” may very well differ from those
used by the central banks. A longer forecast horizon
would then potentially give rise to ever bigger
divergences between the respective forecasts.
Another reason why the lead time may have shortened
is that the behavior of inflation has evolved. This is
typically analyzed by using a Phillips curve framework
where a decline in the unemployment rate is
accompanied by an increase of inflation. If the curve is
L-shaped rather than linear, the central bank would wait
until the unemployment rate approaches the nonaccelerating inflation rate of unemployment (NAIRU)
before hiking its policy rate. In this respect, chart 6
shows that the relationship has been more L-shaped in
comparison with the historical convex relationship.
The second factor that influences the debate about the
December decision by the Fed concerns the recent data
flow. The international environment has deteriorated on
the back of the growth slowdown in China, and growth
has turned negative in several developing economies. In
the press release that followed its January 2016
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Phillips curve (1986 to 2015)
5%
Growth in nominal wages
R² = 0,7
4%
3%
09'Q4
15'Q4
2%
1%
Unemployment rate
0%
3%
Chart 6
4%
5%
6%
7%
8%
9%
10%
11%
Sources: Thomson Reuters, BNP Paribas
meeting, the Federal Reserve did acknowledge that it is
concerned about the global economic and financial
environment. In addition, the effective US dollar has
strengthened significantly, which should weigh on exports,
the decline in oil prices has hit the US energy sector and
corporate bond spreads have widened.
A third factor is the view that the Fed may have missed
the window of opportunity to start hiking in 2014 when the
environment looked better than it does today. As shown in
chart 7, the most recent tightening cycles started in the
context of an improving labor market and a manufacturing
sector that was doing well. In this cycle, the first rate hike
occurred when the manufacturing sector was already
showing clear signs of weakness, as has been witnessed
by the steep decline in the manufacturing ISM index.
US policy rate cycle and the economic environment
ISM manufacturing
Effective federal
funds rate
65 9
8
60
7
55 6
5
50
4
45 3
2
40
1
35 0
Civilian employment /
population ratio
67
65
63
61
59
57
90 92 94 96 98 00 02 04 06 08 10 12 14 16
Chart 7
Sources: Thomson Reuters, FRED, BNP Paribas
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The view that the decision may have come too late does
not mean that inflation is about to pick up sharply and
the Fed would need to play catch-up. On the contrary, it
implies that growth is already slowing, inflation will not
accelerate and the monetary policy’s room for maneuver
should have been created earlier on to enable easing
when necessary. The argument of creating leeway for
subsequent cuts is an important one: previous cycles
have seen significant reductions in policy rates so it is
understandable that the central bank would like to build
a cushion to be ready when the next recession hits.
Theoretically, this makes Fed-watching by market
participants more difficult because the reaction function
of the FOMC would depend on the distance from the
policy targets (inflation, growth) and the ambition to
“build a cushion”. In practice, one can suppose that the
latter point will be only a side-effect of policy decisions
driven by economic data rather than the other way
around.
Central bank communication on monetary
policy
In recent decades, central bank communication has
gone through profound changes. In the 1980s and ‘90s,
the FOMC members voted on the expected direction of
change in the policy stance between meetings, but this
information was made public only after the following
meeting. As of February 1994, a statement describing
the current stance was released immediately after the
meeting, and as of May 1999 forward looking
statements were introduced11. Gradually, forward
guidance became of key importance in the
communication of monetary policy intentions. On the
one hand, the intent was to avoid market disruption on
the occasion of subsequent changes, in particular
increases, in the policy rate and on the other, to avoid
the possibility that market anticipation of a tightening
could cause a sharp spike in the yield curve and have a
detrimental impact on economy activity. In practice a
distinction is made between Delphic and Odyssean
forward guidance. In the case of the former, the central
bank communicates on likely policy action based on its
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macroeconomic forecasts without, however, precommitting. In the case of Odyssean forward guidance,
there is a public commitment to act in a certain way12.
Typically, Delphic guidance is used. It can be timedependent or data-dependent, in which case explicit
reference is made to certain economic indicators (e.g.
the unemployment rate)13.
a low level of official interest rates would make investors
more sensitive to surprisingly strong economic data, in
particular as we get closer to threshold levels in a
context of data-dependent forward guidance. For this
reason, the Federal Reserve has adapted its
communication in recent years in line with the ongoing
decline in the unemployment rate16.
Guidance is important for at least two reasons. First,
recent research shows that forward guidance has a
bigger impact on the US yield curve than do the Fed’s
comments on economic conditions. The impact of
guidance on equity prices is 3 to 4 times greater than
that of communication on the economy. To put it
differently, market participants are able to assess what
the data mean for the state of the economy, but they are
particularly sensitive to the guidance from the central
bank on how the data will shape its behavior.14
Guidance allows investors to better understand and
anticipate the central bank reaction function to the
evolution of the economy. The second reason follows
from this. If guidance is so important and effective in
steering expectations, the implication is that it reduces
uncertainty and hence risk aversion. This means that in
a forward guidance environment, the risk premium
required by investors should be lower and the prices of
risky assets like equities, corporate and emerging bonds
should be higher. For government bonds, one would
expect a lower term premium, implying that investors
demand less compensation for taking duration risk when
buying long-dated paper.
An interesting aspect of the Federal Reserve guidance
is the “dot plot”. This was introduced in January 2012
and shows anonymously the FOMC members’17
“assessments of the path for the target federal funds
rate that they view as appropriate and compatible with
their individual economic projections”18. The semantics
are particularly important: “assessments” and
“projections” imply that they should not be considered as
forecasts, although this begs the question of whether
this reduces their relevance. In addition, there is a risk of
biased assessments. The FOMC members have no
interest in providing an assessment that rates will be
very low on the basis that inflation is expected to be very
low and well below the Fed’s objective because
investors would wonder why the Fed is not taking
additional steps to boost inflation. Does this mean that
the inflation objective has been lowered? Does it mean
that FOMC members question the effectiveness of their
policy? The possibility of such a bias will, however,
weigh on the short-term relevance of the “dots”. Since
they were introduced, they have been well above the
market-implied future Fed funds rates. Sometimes this
has been interpreted as showing that the market
considers Janet Yellen to be the ultimate decisionmaker in terms of monetary policy, whereby she is
perceived to be more dovish than the median FOMC
member. It could also mean that the market disagrees
with the Fed view. In addition, changes in the
assessments have brought the median dots closer to
the market-implied forecasts, which could create a
feeling amongst investors that the market is doing a
better job than the FOMC assessments. However, this
can be a double-edged sword: a batch of important
positive data surprises could cause an upward revision
of the FOMC dots, which would weigh on market
sentiment.
However, for the very same reasons, guidance can
make policy tightening trickier. If asset valuations have
risen because of the reduction in uncertainty, it could
imply a greater sensitivity to economic news and to the
possibility of a change in the central bank’s reaction
function. Research shows15 there is significant time
variation in the reaction of US bond yields to economic
news. Yields rise less in response to positive surprises
in the labor market data when risk, as proxied by the
level of the VIX, is high and the rate of Federal funds is
high. Based on this finding, one can argue that a low
risk environment (because of the forward guidance) and
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Median estimates for Federal Funds rate ("Dots")
4,0
4.0
Dec 15
Sep 15
Mar 15
Jun 15
3.5
3,5
Dec 14
Sep 14
Jun 14
Mar 14
Dec 13
Sep 13
Jun 13
Mar 13
Sep 12
Jun 12
Apr 12
Jan 12
3,0
3.0
2.5
2,5
2.0
2,0
1.5
1,5
1.0
1,0
0.5
0,5
0.0
0,0
Chart 8
2012
2013
2014
2015
2016
2017
February 2016
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(2015a), cannot be observed: “it is not directly
measurable and must be estimated based on our
imperfect understanding of the economy and the available
data”. For the avoidance of doubt, she adds “I would
stress that considerable uncertainty attends our estimates
of its current level and even more to its likely path going
forward”. All this implies that investors will need to gauge
how the Fed will react to incoming data and how the Fed’s
assessment of the neutral rate is evolving. Guidance from
the central bank will be particularly important in order to
avoid abrupt market reactions.
2018
Sources: Federal Reserve, BNP Paribas
An additional element of complexity is the role of the
neutral rate of interest in setting the policy rate19. Yellen
(2015a) explains that in the US the neutral rate of interest,
“which is the value of the Federal funds rate that would
neither be expansionary nor contractionary if the economy
were operating near its potential”, fluctuates over time and
has dropped significantly with the 2008 crisis. In real
terms it has been negative ever since. This low level “may
be partially attributable to a range of persistent economic
headwinds that have weighed on aggregate demand.
These headwinds have included tighter underwriting
standards and limited access to credit for some borrowers,
deleveraging by many households to reduce debt
burdens, contractionary fiscal policy at all levels of
government, weak growth abroad coupled with a
significant appreciation of the dollar, slower productivity
and labor force growth, and elevated uncertainty about
the economic outlook” (Yellen (2015a)). In assessing the
appropriateness of the monetary policy stance, a
comparison needs to be made between the Federal funds
rate and the neutral rate of interest. This implies that the
reaction function of the FOMC will also depend on its
assessment of this rate. Starting from an easy monetary
policy stance, surprisingly strong data would justify a
policy of tightening, but if the FOMC were of the view that
the neutral rate had increased as well, it would need to
tighten more aggressively to reduce the gap between the
effective Federal funds rate and the (rising) neutral rate20.
This approach can be a source of market volatility
because the neutral rate, as emphasized by Janet Yellen
Climbing up and down the risk ladder
According to Orphanides (2015), the fear of a lift-off in
policy rates is rooted in what he calls the “muddled
mandate” of the Federal Reserve with goals of maximum
employment, stable prices and moderate long-term
interest rates. After a deep recession, he sees the
possibility of a temptation to explore the limits of what
“maximum employment” means, something which could
give rise to stop-go cycles. One can argue that the
asymmetric bias in the policy stance (better to take risks
with inflation than to cause a recession by tightening in a
premature way) to some degree reflects this, although the
asymmetry may also quite simply reflect the uncertainty
that the central bank needs to confront when setting rates.
Such an asymmetric stance can influence asset prices
because it would imply that policy rates would be low for
longer (compared with a symmetric stance), which in turn
could support the price of financial assets.
Concerns about the reaction of financial markets to an
abrupt lift-off have been aired by Yellen (2015b): “If the
FOMC were to delay the start of the policy normalization
process for too long, we would likely end up having to
tighten policy relatively abruptly to keep the economy from
significantly overshooting both of our goals. Such an abrupt
tightening would risk disrupting financial markets and
perhaps even inadvertently push the economy into
recession. In addition, continuing to hold short-term interest
rates near zero well after real activity has returned to
normal and headwinds have faded could encourage
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excessive leverage and other forms of inappropriate risktaking that might undermine financial stability.” To put it
differently, tightening too late could end up causing a
severe market reaction, all the more so as in the meantime,
the ongoing low rate environment would have stimulated
investor appetite for risk. However, a premature hike could
also weigh on markets because they would understand the
detrimental impact on growth. In both cases, it can be
argued that the root cause is a policy mistake and the
market reaction is only a transmission channel, not different
from its role when interest rates were being cut and
quantitative easing introduced.
An important question is whether investor risk aversion can
develop endogenously. If this were the case, it would imply
a re-pricing of risky assets (equities, corporate bonds,
emerging debt, etc) even though the Federal Reserve
would not have made any policy mistake or made any
communication mistake. Admittedly, the word
“endogenously” implies that there is another factor that
causes an initial increase in risk aversion, but subsequently,
and this is the key point, the increase in risk aversion
becomes self-reinforcing. Theoretically, such an evolution is
a distinct possibility. The literature on uncertainty
emphasizes that recessions increase uncertainty, which
then feeds on itself21: a recession increases the risk of bad
outcomes. Households and companies become more
cautious and cut back on spending, which confirms their
initial worries and as a consequence they feel even more
uncertain. When this framework is applied to risk aversion,
merely getting closer to the first rate hike already increases
uncertainty and possibly risk aversion, if only because the
debate in markets shifts from “how long will rates remain
unchanged?” to “what is the likely range for the Federal
funds rate within one year?” This was illustrated by the
market reaction to the tapering “announcement” by Ben
Bernanke in 2013. On 22 May of that year, Ben Bernanke
replied to a question during a hearing before the joint
economic committee of the US Congress by saying “If we
see continued improvement and we have confidence that
that is going to be sustained, then we could in the next few
meetings, take a step down in our pace of purchases.”22.
This seemingly benign statement did have a big negative
impact on financial markets across the globe. This was all
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10
February 2016
the more surprising as in the meantime, and for an
undefined period, the monthly asset purchases of the
Federal Reserve would continue. Clearly, investors did not
focus on the flow aspect of these operations but were more
concerned about the implications for stocks, meaning that
the cumulative monthly purchases would turn out to be
smaller than initially thought23.
A factor that could fuel the endogenous rise in risk
aversion is investor positioning. The adoption by central
banks across the globe of a very expansionary
monetary policy has boosted risk appetite on the basis
of a push and a pull effect. The former refers to the idea
that the stance of central banks was reducing economic
and market risk. For the former this was clear from the
evolution of economic data whereas chart 9 shows the
impact on the stock market. One clearly sees a decline
in the frequency of weeks of negative performance of
the S&P500 during the period of non-conventional US
monetary policy.
Weeks with negative performance of the S&P500
2009
0,000
0.000
-0.005
-0,005
-0.010
-0,010
-0.015
-0,015
-0.020
-0,020
-0.025
-0,025
-0.030
-0,030
-0.035
-0,035
-0.040
-0,040
-0.045
-0,045
-0.050
-0,050
-0.055
-0,055
-0.060
-0,060
-0.065
-0,065
-0.070
-0,070
-0.075
-0,075
-0.080
-0,080
2010
2011
2012
2013
2014
2015
QE3
QE1
Chart 9
QE2
MEP
Sources: Thomson Reuters, BNP Paribas calculations
The pull effect reflects the attraction of riskier asset
classes in an environment of very low levels of shortterm interest rates and government bond yields24. Taken
together, both effects explain why investors were happy
to “climb the risk ladder” in their quest for yield. As
explained in the box, this made investors more sensitive
to changes in the market environment, e.g. the outlook
for monetary policy.
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Box: The quest for yield and endogenous swings in risk aversion
The impact of an extensive period of very low policy rates, possibly in conjunction with large scale asset purchases
by the central bank, on investor behavior can be illustrated in a mean-variance framework. In this framework, the
investor acts as a return maximizer subject to a maximum risk level or as a risk minimizer, subject to a minimum
expected return. The optimization will be based on expected asset class returns, their variances and co-variances,
i.e. the extent to which asset class returns fluctuate together. Let’s suppose that the investor is a return maximizer,
so he has chosen his maximum risk level based on objective parameters like the investment horizon and the level of
his risk aversion, which is a subjective assessment of his attitude towards risk. Different investors will have different
risk tolerances, and for each level of risk an optimal portfolio can be built. This portfolio maximizes the expected
return for a given level of risk, and the combination of the expected returns/risk pairs is shown in the efficient frontier.
In the chart below, portfolio A is an optimal portfolio. To the extent that the risk parameters and expected returns
don’t vary too much, the portfolio composition will be rather stable. The investor will be in his “preferred habitat” and
the expected portfolio return corresponds to his objective, i.e. his target return.
Expected
return
Preferred habitat
A
Efficient frontier
Risk
Figure 1
Let’s now assume that we enter a low rate environment that is expected to last. The investor will not, at least initially,
be inclined to lower his target return, and as a consequence he moves up the risk ladder to portfolio B or even C.
Due to the expansionary monetary policy, asset prices have increased and the expected returns have gone down:
the efficient frontiers have shifted downwards. Climbing the risk ladder may be a very easy thing to do
psychologically: the central bank policy provides the comfort that economic and financial risk is under control and
recent asset price appreciation can cause momentum effects and herd behavior (even though the expected returns
decline).
economic-research.bnpparibas.com
Expected return
Expected
return
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Preferred habitat
A
B
C
B
Target
return
C
Risk
Figure 2
However, gradually investor unease will increase: asset valuations may become stretched or there is concern that
monetary policy will start to normalize. Moreover the investor will realize how different his current portfolio
composition is from where it was in “normal times”. The further he moves from his preferred habitat, the greater the
investor’s unease becomes, as is shown in the following chart.
"Feeling of unease"
Expected return
Expected
return
Preferred habitat
A
A
Target
return
B
B
C
C
Risk
Figure 3
A high feeling of unease will in all likelihood lead to increased sensitivity to economic data surprises, to central bank
communication and decisions and, quite simply, to uncertainty.
economic-research.bnpparibas.com
International spillovers
US monetary policy has repercussions on other economies,
obviously via the trade channel (if the policy succeeds in
boosting US growth, it will also raise imports from the rest of
the world) but also more directly via short-term interest rates
and financial markets in general. With respect to interest
rates, the BIS (2015) starts by observing that “as monetary
policy eased in the United States in the wake of the Great
Financial Crisis of 2007–09, short- and long-term interest
rates also fell in countries not directly affected by it”. This
could reflect a synchronization of business cycles, the
presence of common factors driving interest rates or
monetary spillovers whereby the Federal Reserve policy has
an impact on rates in other countries beyond what would be
expected based on other economic linkages25. Global risk
appetite could also be influenced by US monetary policy.
Based on econometric research the BIS (2015) finds strong
spillover effects from US bond yields on global bond yields,
but there is also, albeit to a lesser degree, an influence on
short-term interest rates in developing economies and small
advanced economies. This means that a reduction in US
policy rates also pushes down short-term rates in these
countries. This could reflect an effort of these countries to
discourage speculative capital inflows and hence avoid an
appreciation of their currencies as this could weigh on growth.
The implication, however, is that monetary policy may
become too loose in view of domestic economic
fundamentals like growth and inflation. This could have a
number of consequences, including an increase in inflation,
too fast a rate of credit growth, increased corporate leverage
and an increase of debt in foreign currency if the domestic
currency appreciates.
Does this mean that these dynamics go in reverse when US
monetary policy is being tightened? Not necessarily. The BIS
(2015) states that “It might well be that spillovers are not fully
symmetrical,” although this doesn’t express a view on what
future spillovers will look like. What is clear, though, is that the
“taper tantrum” in 2013 did have a considerable impact on
the bond yields and exchange rates of developing economies
and that there was renewed pressure in 2015. Part of it was
related to the prospect of the first rate hike by the Federal
Reserve, but other factors were at play as well. Financial
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13
market turmoil in China, reflecting concerns about the outlook
for growth, weighed in particular on China’s trading partners.
Moreover, the decline in commodity prices hit the currencies
of commodity exporters. This decline has been associated
not only with slower growth in China but also with a stronger
US dollar, which can weigh mechanistically on commodity
prices as they are priced in dollars. This means that
commodity prices would be another channel of global
transmission of a tightening in the US. This has resulted in a
significant appreciation of the effective exchange rate of the
dollar (chart 10) and indirectly in the tightening seen in the US
financial and monetary conditions index (chart 11). It seems
that we have gone full circle: the very expansionary policy of
the Federal Reserve generated spillover effects, but they
were reversed as we were getting closer to the start of policy
normalization. Moreover, these effects may already have
influenced the stance of the FOMC or still might do so.
Effective exchange rate of the US dollar
130
Broad index Jan. 2010 = 100
125
Real effective exchange rate
120
Nominal effective exchange rate
115
110
105
100
95
90
08
Chart 10
09
10
11
12
13
14
15
16
Sources: Federal Reserve, BNP Paribas
US financial and monetary conditions index
4
US FMCI
3
2
1
0
-1
-2
-3
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Chart 11
Sources: Macrobond, calculations BNP Paribas
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


The Fed tightening cycle is a matter of concern for a
variety of reasons, no matter how gradual it is. There is
the possibility of a policy error, although this will be
discernible only after the fact. There could be a
communication issue if the market reads Federal
Reserve statements in a more hawkish way than
intended by Fed. There could be a change in the
reaction function with the FOMC suddenly reacting in a
more aggressive way. An endogenous, self-reinforcing
increase in risk aversion is a distinct possibility and
could eventually have consequences for the real
economy. International spillovers could, like a
boomerang, end up having an impact on the US, so an
appropriate policy from a domestic perspective could
become inappropriate from a global perspective. In
addition, a data-dependent monetary policy is more
complex to read: it reflects a concern at the level of the
Fed that it is difficult to forecast in a reliable way beyond
the next several months or that it is difficult to gauge
how the economy will react to its tightening policy. In
both cases this should lead to more volatility in markets.
All of these factors together are a reminder that whereas
an easing environment reduces economic and market
risk, a tightening environment brings this risk back and
causes structurally higher uncertainty and volatility.
Completed 19 February 2016
[email protected]
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NOTES
The federal funds rate is the rate banks charge to each other for overnight loans. They take these loans so as to have the necessary funds to
meet the reserve requirements of the Federal Reserve System. By means of open market operations (buying or selling of government securities),
the Federal Reserve sees to it that the effective Federal funds rate is very close to the target rate as set by the FOMC (source: Federal Reserve
website).
2 The Federal Reserve provides the following definition on its website: “The term "normalization of monetary policy" refers to plans for returning the
level of short-term interest rates and the Federal Reserve's securities holdings to more normal levels. At its December 2015 meeting, the FOMC
decided to begin the normalization process by modestly raising its target range for the federal funds rate.”
3 The zero lower bound refers to the fact that the nominal policy rate is close to 0%. It implies that when banks borrow from the central bank, the
nominal rate is virtually zero. However, the deposit rate charged by the central bank can be negative, as is seen in several European countries and
in the Eurozone. Reserves at the Fed are still receiving a positive rate of interest nonetheless (0,50%).
4 The list of risks and challenges is not exhaustive. A particular concern is the risk of reduced market liquidity in case volatility picks up. This will
not be covered in this article.
5 See Kohn Donald L. (2010) for an overview.
6 See Fischer (2015)
7 See https://www.frbatlanta.org/cqer/research/shadow_rate.aspx?panel=1
8 As explained later on in greater detail, this refers to comments by Federal Reserve chairman Ben Bernanke that at some point, if data justify it,
the Federal Reserve would scale back its monthly purchases made in the context of its quantitative easing policy.
9 This doesn’t stop some analysts from having very clear-cut opinions. Danielle DiMartino Booth, a former advisor to the Federal Reserve Bank of
Dallas, published an opinion piece in the Financial Times on 4 February 2016 under the title “The messy aftermath of the Fed’s historic mistake”
referring to the December 2015 rate hike.
10 This also explains, as discussed later in the text, the major increase in the attention paid to how central banks communicate to the markets. The
element of market reaction was clearly present in Janet Yellen’s Amherst speech in September 2015 (Yellen (2015b)).
11 Campbell et al (2012)
12 Campbell et al (2012)
13 To illustrate this point, the press release after the 30 January 2013 meeting stated: “the Committee decided to keep the target range for the
federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least
as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half
percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In
determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including
additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments”
(source: Federal Reserve website).
14 Source: Stephen Hansen, Michael McMahon, The nature and effectiveness of central-bank communication, 03 February 2016, www.voxeu.org
15 Linda S. Goldberg and Christian Grisse, Time Variation in Asset Price Responses to Macro Announcements, , Federal Reserve Bank of New
York Staff Reports, no. 626, August 2013
16 The reference to a specific unemployment rate as a conditioning factor for a possible change in the policy rate was dropped at the 19 March
2014 meeting: “With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. The change in the
Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.” (Source: Federal
Reserve website).
17 These are the 5 members of the Board of Governors and the presidents of the 12 Federal Reserve Banks.
18 Source: Federal Reserve, Minutes of the Federal Open Market Committee, January 24–25, 2012
19 This concept is reminiscent of the “natural rate” that is associated with Knut Wicksell, who “posited that the natural rate would be equal to the
real interest rate that would balance supply and demand absent monetary frictions” (Yellen (2015a)).
20 “Stronger growth or a more rapid increase in inflation than we currently anticipate would suggest that the neutral federal funds rate is rising more
quickly than expected, making it appropriate to raise the federal funds rate more quickly as well” (Yellen (2015a)).
21 See e.g. Nicholas Bloom, Fluctuations in Uncertainty, NBER Working Paper No. 19714, December 2013
22 Source: http://www.jec.senate.gov/public/
23 Interestingly, in Europe the opposite happened when on 3 December 2015, the Governing Council of the ECB announced an extension of its
asset purchase program (QE), implying a bigger cumulative volume without, however, stepping up the pace of monthly purchases. On that
occasion, investors were focusing on the flow aspect rather than the impact on stocks.
24 See BIS (2014) for statistics on inflows into emerging markets and high yield bond funds.
25 International monetary spillovers, BIS Quarterly Bulletin, September 2015, p. 105
1
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References
BIS (2014), Volatility stirs, markets unshaken, BIS Quarterly Bulletin, September 2014
BIS (2015), International monetary spillovers, BIS Quarterly Bulletin, September 2015
Bloom Nicholas (2013), Fluctuations in Uncertainty, NBER Working Paper No. 19714, December 2013
Campbell Jeffrey R., Evans Charles L., Fisher Jonas D. M., Justiniano Alejandro (2012), Macroeconomic Effects of
Federal Reserve Forward Guidance, Brookings Papers on Economic Activity, Spring 2012
DiMartino Booth Danielle (2016), The messy aftermath of the Fed’s historic mistake, Financial Times, 4 February
2016
Federal Reserve (2012), Minutes of the Federal Open Market Committee, January 24–25, 2012
Fischer Stanley (2015), Conducting monetary policy with a large balance sheet, speech at the 2015 U.S. Monetary
Policy Forum Sponsored by the University of Chicago Booth School of Business, 27 February 2015
Goldberg Linda S. and Grisse Christian (2013), Time Variation in Asset Price Responses to Macro Announcements,
Federal Reserve Bank of New York Staff Reports, no. 626, August 2013
Hansen Stephen, McMahon Michael, The nature and effectiveness of central-bank communication, 03 February
2016, www.voxeu.org
Joint Economic Committee (2013), http://www.jec.senate.gov/public/
Kohn Donald L. (2010), The Federal Reserve's Policy Actions during the Financial Crisis and Lessons for the Future,
speech at the Carleton University, Ottawa, Canada, May 13, 2010
Orphanides Athanasios (2015), Fear of Liftoff: Uncertainty, Rules and Discretion in Monetary Policy Normalization,
Institute for Monetary and Financial Stability, Goethe University, Frankfurt am Main, working paper series, n° 95
Wu Jing Cynthia and Xia Fan Dora (2014), Measuring the Macroeconomic Impact of Monetary Policy at the Zero
Lower Bound, Chicago Booth and NBER, Merrill Lynch, 20 July 2014
Yellen Janet (2015a), The economic outlook and monetary policy, The Economic Club of Washington D.C.,
December 2015
Yellen Janet (2015b), Inflation dynamics and monetary policy, The Philip Gamble Memorial Lecture University of
Massachusetts, Amherst, Massachusetts, September 2015
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