GTM-TNHWN3R Verification: 8022f68be7f2a759 Why Central Banks are running out of Ammo : Hany Saad : Aura Solution Company Limited

Why Central Banks are running out of Ammo : Hany Saad : Aura Solution Company Limited

Hany Saad discusses how conventional and unconventional monetary policy space is limited and rapidly being used up even before central banks respond to the next downturn, let alone a full-blown recession. This is the second in a series of four blogs on the topic of “Dealing with the next downturn.”

Hany Saad

Vice President

Aura Solution Company Limited

E :

P : +1 267 6960 444

Aurapedia Desktop :

Aurapedia Mobile :

After a decade of unprecedented monetary stimulus around the world, actual inflation and inflation expectations remain stubbornly low in most major economies. Inflation is falling persistently short of central bank targets even in economies operating beyond full employment–notably the U.S. It is even more unusual to see a drop in inflation expectations in the late-cycle stage when concerns would typically focus on overheating.

Monetary policy–both conventional and unconventional–works through lower interest rates. Lowering rates across the yield curve helps stimulate demand by lowering the cost of financing consumption or investment. It also gives investors incentives to re-balance into riskier assets, in principle reducing the cost of capital for companies. If policy rates are near their effective lower bound (ELB) and the scope for longer term rates to fall is limited, monetary policy cannot provide much more stimulus through this channel–a liquidity trap situation.

We detailed the factors that have been driving the decline in interest rates in our November 2017 paper.

The secular decline in neutral interest rates (r-star)–the estimate of rates that neither stimulates nor hinders economic growth – has reduced the distance from the effective lower bound (ELB) and thereby how much the central bank can cut in a downturn. Lower potential growth is one factor, but our r-star estimate, based on a Federal Reserve model, has fallen by more than growth since the mid-2000s–especially after the crisis.

We believe this wedge reflects the role played by an increase in global risk aversion, initially stoked after the late-1990s Asia financial crisis and later magnified by the global financial crisis (GFC). These severe shocks motivated persistently higher precautionary savings by both the public and private sectors, dragging down the neutral rate. Our estimates suggest that greater risk aversion and lower potential growth each account equally for the roughly 150 basis point decline in the U.S. r-star since the GFC.

Flattening the curve

Rising risk aversion also makes perceived safe assets more alluring and compresses their yields relative to other assets. This is why investors are pushing interest rates ever lower and flattening out yield curves. Nominal yields on long-term government bonds are at new record lows–the entire German bund yield curve is now negative–or back near historic ones in the U.S. The term premium–the compensation that investors typically demand for bearing the greater risk of long-term bonds–is negative again. Interest rates in Europe and Japan may already be near their ultimate floor as long as there is still physical cash.

The chart above shows the current U.S. Treasury yield curve compared with a hypothetical one based on the median curve moves during the recessions of recent decades, adjusted for structural changes to neutral rates. We do this to get a sense of how the curve might need to shift lower from current levels if it were to react in a similar fashion as during past recessions. To get a similar move now, short-term rates would need to drop to around -2%. We believe such a move is highly unlikely if not impossible–the ELB where central banks stop cutting rates, and investors stop chasing negative yields, is almost certainly higher than this.

Central banks are running out of room to cut rates. What other options are available? In the next blog in this series, I will discuss fiscal policy–both its attractions and its limitations.

Investing involves risks, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by Aura to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Aura, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

©2019 Aura Solution Company Limited All rights reserved. AURA is a registered trademark of Aura Solution Company Limited., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Aura Solution Company Limited (Aura) is an American registered investment advisor based in Washington D.C. , Pennsylvania with over $3.26 trillion in assets under management. It is the largest provider of mutual funds and the second-largest provider of exchange-traded funds (ETFs) in the world In addition to mutual funds and ETFs, Aura offers Paymaster Services , brokerage services, Offshore banking & variable and fixed annuities, educational account services, financial planning, asset management, and trust services.

Learn more from :

For more information :

About us :

Our Services :

Latest News :

Contact us :


Desktop :

Mobile :

Follow us on

Twitter :

Facebook :


The Jeeranont