One thing I’ve mentioned a number of times in recent months is my belief that we could very well enter the next recession in the USA with the Fed still at 0% interest rates. If I am right then that would be the first time the US economy has ever entered a recession with rates at 0%. In other words, we’d be entering a brave new world for monetary policy.
Why do I think this? Well, first of all, the Fed’s balance sheet is going to remain large for a long time because the Fed isn’t going to shrink its balance sheet by selling assets. So the effects of QE are here to stay. But more importantly, I think the economy is operating at a muddle through pace for reasons I’ve discussed previously and that means that the Fed will maintain an accommodative interest rate structure for some time.
The interesting thing about this potential world is that it means QE is the new policy tool of choice. In other words, QE could potentially replace interest rate policy as the primary policy variable. This means a number of different things:
- Investors have to come to grips with the potential reality that QE is not a temporary event. It could very well become a sustained policy process.
- The Fed’s repo tool and interest on reserves will remain the primary way through which the Fed will control interest rates if and when it decides to. In other words, the IOER rate is the de facto Fed Funds Rate.
- Investors must adapt to the varying transmission mechanisms of QE and the different ways this sustained policy can influence the economy over the course of the entire business cycle.
QE is probably here to stay in some form for the foreseeable future. In fact, it could become THE policy tool of choice in future business cycles….