Shadow Rates Prove 'Too Easy' Monetary Policies

Includes: EEM, GLD, SLV, SPY, VDE
by: Disruptive Investor

In general, the level of nominal short-term interest rates is taken to indicate the stance of policy. Lower values are described as easy policy and higher value as a tight policy stance. The FOMC's policy rate has been effectively pegged at near-zero levels since December 2008. How would one describe the monetary policy stance given this development?

The shadow policy rate is used to provide a gauge of the monetary policy stance after the actual policy rate reaches zero. This article discusses the current shadow policy rate and concludes on the policy stance taken by U.S. policymakers. I will take input from the discussion paper by the Reserve Bank of New Zealand - Measuring the stance of monetary policy in zero lower bound environments by Leo Krippner. I will also take chart inputs from St. Louis Fed's presentation on the same topic.

Before discussing the shadow rates using the Leo Krippner model, I would like to discuss the Taylor (1999) rule for recommending policy rates. The formula below gives the calculation method, which uses PCE inflation, output gap and the unemployment rate to recommend policy rates.

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It is possible to plot the recommended policy rate according to the Taylor rule. However, it does not make much sense as negative short-term rates can't be recommended. The chart below shows the recommended policy rate using the Taylor rule. I am discussing this as it would help determine the variance between recommended policy rate and the shadow rate according to the Leo Krippner model.

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Coming back to the Leo Krippner model, it was way back in 1995 when Fischer Black provided a way to calculate the value of the call option to hold cash at the zero lower bound in his paper - Interest Rates as Options. Fisher suggested that the value of the option can then be subtracted from observed nominal yields. This leaves a shadow nominal yield curve that would exist in the absence of the cash option. Leo Krippner suggested modifications to Black's approach by using the implied shadow overnight rate as a metric for the actual stance of monetary policy. Using the approach, the chart below gives the yield curve at zero lower bound and the shadow yield curve. Very clearly, the currency option effect leads to a meaningfully different shadow yield curve giving the real policy stance at zero interest rates.

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If one did consider that Taylor's policy rate recommendation holds well, it is possible to compare the recommended policy rate to the actual policy rate. This variance will show if the actual policy rate is too easy. The chart below gives the effective Fed fund rates, Taylor's recommended policy rate and the shadow interest rate by Leo Krippner.

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Currently, the shadow policy rate is more than 300bps lower than the recommended Taylor (1999) rule. Very clearly, the policy stance is ultra accommodative. Due to a very high output gap, there was a sudden slump in Taylor's prescribed rates in early 2009. At that point of time, the shadow rates suggested relatively tight policy stance. However, post that period, the policy stance has been highly accommodative and has remained the same with an improving economy.

It would also be interesting to plot shadow Fed fund rates based on the guidance given by the Fed. As of October 2012, the forward shadow interest rates suggested that the policy stance will remain accommodative into 2015. There is no doubt in my mind that such a prolonged easy policy stance will lead to high inflation. I had discussed the inflation and the expected Treasury market trend in two of my earlier articles - PIMCO's Gross on Free Money and Treasury Bull Run is Over; Inflation Will Take Centre Stage.

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Before discussing some investment ideas, I would also like to present a chart, which shows the impact of QE on shadow interest rates. As the chart shows, shadow interest rates have declined to further negative territory on each successive QE. From this perspective, the objective of QE has been met. However, QE has done little for real economic recovery.

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I would also like to mention that Taylor's prescribed policy rate recommendation uses output gap as one of the parameters to recommend policy rates. However, using output gap for recommending interest rates might be a flaw as pointed out by James Bullard, the President and CEO of Federal Reserve Bank of St. Louis in his speech - Inflation Targeting in the USA.

According to Bullard -

The recent recession has given rise to the idea that there is a very large "output gap" in the U.S. The story is that this large output gap is "keeping inflation at bay" and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States.

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the "potential" output of the U.S. should be. By that type of calculation, we are indeed stunningly far below where we should be, perhaps 5.5 percent below, using data through the fourth quarter of 2011. What is more, we have made little progress in closing the gap defined in this way, because real GDP has only grown at modest rates since the recession ended in the summer of 2009. And furthermore, using current GDP forecasts from, say, the Blue Chip consensus, we have little prospect for closing the gap any time soon.

Is this really the right way to think about where the U.S. economy should be? I do not think it is a defensible point of view. Let me give you some of my perspectives. Most analysts seem to agree that the middle part of the 2000s was characterized by a "bubble" in the housing sector. Housing prices were high and rising fast compared to nominal GDP. It is not prudent to extrapolate a bubble into the indefinite future and claim that such a calculation provides a good benchmark. Yet, that is what we are doing when we extrapolate fourth quarter 2007 real GDP. Furthermore, we normally have the good sense not to do this in other economic situations.

The point I am trying to make here using Bullard's observation is that the recommended policy rate using Taylor's rule should be higher than the current observation, which incorporates the output gap. A large output gap is certainly not the best reason to keep interest rates artificially low. In other words, the divergence from the recommended policy rate is greater than 300bps. I would call this an ultra expansionary and an ultra accommodative monetary policy.

In such a scenario, it is extremely important to diversify across regions and asset classes in order to preserve one's purchasing power. I would recommend the following investments -

SPDR S&P 500 ETF (NYSEARCA:SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - Global diversification is necessary, and exposure to emerging markets is critical. Over the long term, emerging markets will outperform developed markets in terms of equity price appreciation. The cumulative mutual fund inflow into emerging markets has been higher in the last five years compared to developed markets. The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly-traded securities in emerging markets, as represented by the MSCI Emerging Markets Index.

SPDR Gold Shares ETF (NYSEARCA:GLD) - Investors can consider exposure to the hard asset for the long term. In the near term, some more correction in the precious metal is entirely likely. However, expansionary monetary policies and artificially low interest rates will trigger long-term upside in the precious metal. The GLD ETF seeks to replicate the performance, net of expenses, of the price of gold bullion.

iShares Silver Trust ETF (NYSEARCA:SLV) - Very similar to the argument for gold, I am also bullish on silver for the long term. Investors can consider exposure to silver through the purchase of physical metal or the ETF, which seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities.

Vanguard Energy ETF (NYSEARCA:VDE): In times of inflation, investors seek refuge in hard assets. Energy as a sector will do well in times of inflation. The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.