- The US Federal Reserve has been tightening monetary policy since late 2005. Based on latest FOMC forecasts, it expects to deliver two quarter-point increases this year, and another in 2020.
- This has created concern that the Fed may be making a policy mistake, and could trigger a US recession.
- BAML has analysed past Fed tightening cycles to determine whether these concerns are warranted.
- It’s conclusion is definitive: “If there is no inflation problem, Fed tightening does not lead to a recession”.
The US Federal Reserve has been lifting interest rates since late 2005, seeing the Fed funds rate range lift to 2.25%-2.50%.
While markets believe otherwise, the Fed, at least based on the median FOMC member forecast offered in December, still sees another two quarter-point increases in the funds rate this year, and another in 2020.
That’s got markets nervous about the Fed making a potential policy mistake in tightening policy too aggressively when the economy doesn’t need it.
As things stand, you’d be hard-pressed to not find someone who hasn’t read something about the flattening in the US yield curve and its potential inversion, and the history of what that means.
The R-word has been bandied around a lot as a consequence.
But should markets be fearful about further Fed rate hikes, and the potential for those to invert the US yield curve, starting the countdown clock until the next recession hits?
Maybe, but Bank of America Merrill Lynch’s (BAML) US Economics team, lead by Ethan Harris, says further rate hikes may not lead to the doom and gloom that many expect, unless inflation rears its head.
Based on analysis of previous Fed tightening cycles, it says that in the absence of a serious inflation problem, Fed rate hikes have never triggered a recession.
“There are three kinds of Fed hiking cycles,” BAML says.
“If there is no inflation problem, Fed tightening does not lead to a recession, as the Fed backs off from the hikes. In other words, investors who believe the Fed is fighting a phantom menace should be optimistic about growth going forward. Inflation, not the yield curve or the stock market, is the best indicator of recession risks. Hiking cycles in 1984, 1994-5, 1997 all fit this pattern.
“By contrast, if there is a serious inflation problem then the Fed faces a choice of either delaying the day of reckoning or bite the bullet and risk a recession. Indeed, the Fed has never been able to pull off a soft landing for the economy when it is fighting serious inflation.”
BAML says there’s a reason why the Fed has such a tough time fighting serious inflation without triggering a recession.
“Usually late in an expansion rising core inflation is not the only imbalance in the economy,” it says.
“Usually cyclical sectors of the economy have over expanded, along with an associated asset bubble. A third late cycle imbalance is when a tight oil market is hit with some kind of supply shock, causing oil prices to skyrocket. Hence in assessing recession risks it is worth paying close attention to double bubbles and oil markets.”
So where does history say the risk of a recession lies today? Inflation isn’t exactly out of control, so does that mean the coast is clear?
No one can tell what the future holds, but with history as a guide, BAML says the risks appear low at this stage.
“The main risk of a recession in 2019 and 2020 is not that the Fed hikes too fast. That is a correctable mistake, particularly when they hiking at such a slow pace to begin with. The bigger risk from the Fed is that they have already hiked too slowly, slipping behind the curve in preventing either serious inflation or a major double bubble.”
With core PCE inflation — the Fed’s preferred measure of gauging price pressures — sitting at or just below its 2% target, BAML says the Fed will “work hard to achieve a soft landing, cutting or hiking as appropriate”.
“In that case a recession is only likely if there is a huge shock — such as a full-blown trade war — and the Fed is unable to act aggressively enough to offset the fall out,” it says.
“On the other hand, if inflation breaks higher, then investors have real reason to fear the Fed.
“In this case the Fed will likely target very weak, below-potential GDP growth. That weakness can happen through hikes or by letting any shocks that come along do the dirty work. Either way, it puts the economy at a high risk of a recession. If there are other serious imbalances in the economy — which we don’t see — the risks are even higher.”
So rather than what’s happening in the shape of the yield curve, or using the stock market as a guide to what the future holds for the US economy, BAML says its largely inflation that investors should be focused on.
“The ultimate ‘enemy’ here is inflation and other imbalances, not the Fed,” it says.
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