KGB Interview: Neal Soss

Credit Suisse's chief economist, Neal Soss, explores the significance of the conclusion of the Federal Reserve's quantitiatve easing program and the implications for global markets.

The chief economist at Credit Suisse, Neal Soss, tells Business Spectator's Alan Kohler and Stephen Bartholomeusz:

-- The lingering trauma of the global financial crisis is much more pronounced and intense in the United States and Europe than Australia.

-- The market's general consensus of an upward shift in US short-term interest rates in 2015 is a reasonable forecast.

-- One of the risks in ending quantitative easing lies in the intersection of monetary tightening and an untested regulatory regime that will inhibit the transfer of risk. 

SB: Neal, we’ve had nearly six years of these unconventional monetary policies pursued by most of the large, developed economies, yet there’s been very little growth in the real economies as opposed to financial assets. Does that say that the policies haven’t actually worked?

NS: It’s always a question of what is the counterfactual. What would have happened otherwise? And since no one knows, you can only make a judgement about it. I think it’s fair to say that had policies not been adopted that were as stimulative as the central banks knew how to do, things could easily have been much worse.

I’ve only been in Australia the last couple of days -- it’s been regrettably too many years since the last time I visited. One thing I notice in talking to businesspeople and journalists and public officials is that the trauma of the North Atlantic, the lingering memory of how awkward and difficult and painful and frightening that was, is much more intense in the States and Europe and so forth than it is down here. 

You’ve had twenty-two years of uninterrupted economic growth. In some ways you had a good crisis, so to speak, because you had China very eager to buy the raw materials during the period of great distress in the US and Europe. So, it may be hard for you to appreciate just how frightening this all was for us in the North Atlantic.

SB: And when would you expect to see rates to rise in the States?

Neal Soss: The first thing to recognise is that the Federal Reserve chose -- I guess is the right word -- to reduce the asset purchase program, partly in recognition of some improvement in economic performance, partly perhaps out of some concern about the efficacy of the program itself. You don’t want to overuse a medicine.  When you don’t need it, you want to save it up, so to speak, for when it might be more urgently required. 

But I would think that it will be sometime in the middle or second half of 2015. Even that is obviously conditional upon continued improvement in economic performance -- which we expect, but obviously can’t guarantee --and it’s also conditional on some technical issues about how exactly do you adjust market interest rates when your starting position is several trillion dollars of excess reserves in the banking system. 

Do you think that’s a potentially destabilising moment for markets?

NS: That is a reasonable concern, that’s for sure. The episode last summer when markets were certainly shocked by chairman Bernanke’s announcement that the Fed was contemplating cutting back on the asset purchase program, the so-called ‘taper tantrum’, is the sort of thing that people reasonably fear is a precedent for what might happen when rates start to move. 

Having said that, part of the purpose of the Fed in its forward guidance, in the extensive communication in how slowly they’re moving as it is, is perhaps to sensitise the markets to that prospect so that when the time comes, you don’t get an outsized shock. That’s a reasonable policy goal from their perspective. Part of the issue here, of course, is you typically tighten monetary policy because you want to slow something down, which means you want to deliver some degree of shock, but you don’t want a shock that’s so destabilising as to cause real trouble, or at least presumably not. So, it’s a fairly delicate ‘middle of the road’ kind of problem that they face.

Alan Kohler: But Neal, wouldn’t the market already have priced in what you described as being the most likely outcome? We know that they’re going to finish QE in October and the market now expects rates to start rising in the middle of next year, as you predicted. So, wouldn’t it be the case that the market will only be destabilised if things change from that?

NS: It depends on quite how you do your bond math. There are certainly some people who would look at the prospect of the Fed tightening and tightening at the pace that they have already suggested through the so-called dots, the projections that they’ve made. There are people who would do the bond math and say that the short-term interest rates, the two-year notes and so forth, have not fully priced that prospect.  Personally, I’m a little bit sympathetic to the market in saying well, it’s a prospect, but it’s not an assurance, so we don’t have to be fully priced to it. 

There are some ways of doing the bond math that suggest that we’ve got about half of it priced now. That gives us six months, nine months, a year to price the remainder.

AK: Well, presumably that’s not what will occur as long as the guidance doesn’t change between now and next year.

NS: You would expect so. You would expect so and, if that is the sequence, it might not be all that destabilising. Now, I think the thing that the global community fears more than some kind of event in the States is the flow of capital internationally, which recently seems to have been from the developed markets towards the less developed markets and, to some considerable degree, I suppose towards Australia, visible in the exchange rate. 

You don’t want that to reverse too quickly. If that’s going to reverse, you want it to reverse in a very orderly way. Financial history is full of orderly reversals, but the ones we notice are the ones that aren’t so orderly. The ones that make the history books are the ones that are not orderly. So, there’s some concern about that and reasonably so.

SB: Neal, one of the things that Janet Yellen has talked about recently and which is reflected in the Fed’s minutes is mild concern about the unintended consequences of this protracted period of monetary policy, in particular the potential of the people that do not pay enough attention to risks in financial markets. Do you think that’s a containable issue? Is it as modest an issue as Yellen seems to think it is or is there potentially something much deeper lurking beneath the surface?

NS: It’s a difficult question and it’s a bit like the question we were discussing earlier about orderly adjustments to monetary policy tightenings and so forth.  Most of the times these adjustments, although perhaps not pleasant for market participants, are orderly.  The ones we remember most intensely, the vivid ones are the ones that are not so orderly. So, in some sense everybody remembers 1994 in the US bond market because the Fed tightened and the bond market lost its composure. 

On the other hand, in the mid-2000s in the period preceding the financial crisis, the Fed tightened a 0.25 per cent at every meeting for 17 consecutive FOMC meetings. That’s a pretty considerable amount of tightening of policy, but it was very orderly. That was the period when Greenspan was a bit puzzled by what he called a conundrum: how come it’s so orderly? 

So, the answer to your question is yes, there are risks. There always are. I think one of the risks under current circumstances arises from the intersection of tightening policy when, if and as it comes and the new regulatory environment that makes it very difficult for the dealer community to have an elastic balance sheet to achieve the risk transfer from people who want to sell securities to other people who are willing to buy them. The dealers used to facilitate that by taking the assets into inventory and then searching for a counterparty. That sort of behaviour is much more difficult to achieve now because we have higher capital requirements on the dealers, more stringent liquidity requirements on the dealers and so forth. And if there’s a risk to some kind of unstable consequence, I think it probably resides in that intersection. It’s an untested regulatory regime for the beginnings of a tightening cycle. Again, I probably should emphasise that’s not a forecast that something will go bad, it’s the assessment of the form of a risk that might well be taken into account.

SB: Thank you very much for your time, we appreciate it.