31st January 2022
Last week Jerome Powell signalled the Federal Reserve (“Fed”) would shortly commence the next cycle of interest rate rises. How the Fed manages the tightening cycle will be a key issue for asset allocation and investing in 2022.
There has been a significant shift in market expectations in recent months from a position of scepticism about the likelihood of rate increases, to grudging acceptance, to growing fears that the Fed may need to do a 50bps hike to restore credibility at the March meeting.
The complacency was at least partially a response to Fed forward guidance. In 2020 the Fed was “not even thinking about thinking about raising interest rates”. Even in October in 2021, former Fed Vice Chair Clarida suggested the conditions for a rate increase would probably only be met by the end of 2022.
Despite the adjustment in expectations, and some debate about a risk of a 50bps increase March, the base case for markets is still for a gradual series of rate hikes with interest rates peaking at around 2.0%, below the prior peak for nominal Fed funds.
Implied 3-month US $ rate from Eurodollar futures
Source: CME/Archive Capital
Some analysts have been quick look back into the history books and conclude that periods of moderately rising rates tend to be positive for risk assets at least in the initial stage.
But every tightening cycle is different and a number of features of this cycle make it unusual. The risk is clearly that the Fed is forced into a more aggressive tightening at some point in the cycle, which could precipitate a hard landing and significant volatility in markets.
The starting point
The most obvious difference with the past is that the Fed is starting to tighten policy with inflation well above target.
The table below highlights how unusual the current scenario is relative to history. December CPI was over 7% while the Fed’s own target, core PCE was +4.9% versus the 2.0% policy target. As a consequence real interest rates are unusually stimulative.
Historical Tightening Cycles since 1990
Source: FRED/Archive Capital
In 1955 Fed Chairman William McChesney Martin described how it was the role of the Federal Reserve “to remove the punch bowl just as the party was really warming up”. That pre-emptive doctrine underpinned central bank behaviour for decades.
But in this cycle, driven by flexible average inflation targeting, and a desire to extend the benefit of a strong labour market to as many people as possible, the Fed has been topping up the punch bowl (purchasing assets) even as the party got going (inflation well above target).
The current episode is even more unusual because the Fed has had evidence of higher inflation for some time but a lingering suspicion that it was being caused by supply side issues tempered the response.
But now the case for tightening is clear: (1) Yes, inflation may moderate but probably still to a level above target. (2) The policy stance is highly accommodative: rising inflation means that policy (measured in real interest rates) has been getting progressively more accommodative and (3) the economy is strong with employment levels at or possibly above those consistent with full employment.
The key questions for markets now are how much tightening, how fast and what will be mix between rate increases and balance sheet reduction.
The end of gradualism?
The two Fed tightening cycles this century have been marked by a gradualist approach with changes in policy well telegraphed. Under gradualism, the Fed tended to make small incremental changes in policy (such as the series of 25bps hikes between 2004 and 2006).
Target Fed Funds Rate (%), 2004-2022
Source: FRED/Archive Capital
The original case for gradualism was set out by economist William Brainard in a paper in 1967 in what has become known as the Brainard principle. He postulated that when you are uncertain about the effects of your actions, you should move conservatively.
But it wasn’t until the 2000s that gradualism really came into vogue. First, Alan Greenspan at the 2003 Jackson Hole conference, and then Ben Bernanke, in a speech in May 2004, highlighted the merits of gradualism, just as the Fed was about to embark on the tightening cycle following the dotcom recession.
For Bernanke, gradualism reduced the risk of financial instability from monetary tightening, afforded the Fed greater ability to influence long term rates and was the most prudent approach given uncertainty about the economy and how their actions will impact it. While for Greenspan “uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape”.
However, the Brainard principle of gradualism it is not an argument for conservative policy in every situation. The costs and benefits of each policy actions have to be weighed. This aspect was returned to by Fed Chair Powell at Jackson Hole in 2018 when he identified two scenarios when more aggressive policy may be warranted: (1) when policy is approaching the effective lower bound and (2) if there is a risk that inflation expectations get unanchored.
That brings us to the current policy dilemma for the Fed.
At Wednesday’s press conference Powell outlined a tightening framework that was broadly consistent with the typical gradualist approach. The policy stance would go from highly accommodative to less accommodative and to not accommodative over time, but not immediately.
However, when asked specifically would the Fed follow the gradualist approach to raising rates that characterised past cycles, he was more evasive, saying no decisions have been made but highlighting how different the economy is now versus 2016/2017.
Rather than emphasising gradualism and raising rates at a measured pace, the Fed is now emphasising being humble and nimble. Since then Atlanta Fed President Bostic has been on the wires offering his view that 50bp changes may be required if inflation remains high.
The implication seems clear: if inflation doesn’t moderate and if the economy continues to be strong we could be seeing the end of gradualism and the start of a more aggressive Fed.
While the focus over the last few months has been on when the conditions would be met for lift-off, the debate is now about to shift towards the ultimate destination for the policy stance.
In the last tightening cycle, as interest rates rose, investors questioned at what rate of interest was policy no longer accommodative but instead neutral. Or put another way, where is the neutral policy rate, r* (rstar)?
The question was contentious because the growing belief in secular stagnation in the last decade had engendered a perspective that r*may have fallen over time. At Jackson Hole in 2018, Powell provided the Fed’s perspective, namely that it is difficult to estimate the neutral policy rate and indeed the natural rate of unemployment in real time.
For example, with the benefit of hindsight the US economy was running above potential and unemployment was below neutral in the 1960s but that wasn’t appreciated at the time. Equally in the late 1990s the neutral rate of unemployment was overestimated at the time and inflation never took off even as unemployment declined to historical lows.
This time around, much uncertainty centres around labour force participation particularly given the Great Resignation during COVID-19. That’s one reason the Fed monitors a range of labour market indicators to assess full employment rather than solely relying on the unemployment rate.
However, the Summary of Economic Projections released at the December FOMC meeting, give a sense of where the Fed sees neutral policy. The longer run estimate for the Fed funds rate is 2.0-3.0% and for PCE inflation is 2.0%. That implies the Fed thinks neutral real Fed funds is about 0.5%.
Federal Reserve: Summary of Economic Projections, December 2021
Source: Federal Reserve
But of course the actual neutral rate could be higher or lower. The market consensus is that because each successive peak in nominal (and real) Fed funds has been lower (due to financialization of the economy, demographics, greater indebtedness etc), the peak in this cycle will be lower again.
Target Fed funds
Source: FRED/Archive Capital
The challenge for the Fed is that its policy stance is not defined purely by one interest rate: its policies influence the economy via overall financial conditions (not just short rates, but long-term rates, credit spreads and asset prices aswell).
So the impact of say a 2% nominal Fed funds rate on the economy will be different depending on whether getting to that 2% rate causes long-term yields to rise and whether risk assets such as equities and corporate bonds decline in response to a move to 2%.
In addition, interest rates are not the only lever it has to influence financial condition. A key influence this year is likely to be the size of the Fed’s balance sheet.
The importance of the balance sheet
When the December FOMC minutes were released many commentators pointed to the fact that it wasn’t new information on rate increase but it was the discussion of balance sheet reduction that unnerved markets.
In the 2015-2018 cycle, equities were able to withstand gradually higher rates but suffered a 20% drop in 2018 when the balance sheet started to be reduced at the same time as rates were being increased.
S&P 500, Target Fed funds, Fed Balance sheet change
Source: Archive Capital
There remains much uncertainty about the importance of the balance sheet both in terms of its economic impact and market impact. When pressed at last week’s press conference as to how much balance sheet reduction was equivalent to an amount of rate increases Powell declined to give an estimate but said “the balance sheet is still a relatively new thing for the markets and for us so we're less certain about that.”
One of the uncertainties is about whether asset purchases work via the stock or the flow effect. The flow is the impact of the monthly purchases of assets from the central bank, whereas the stock effect is the fact that because of its cumulative purchases the central bank has taken out a chunk of the supply of government bonds and will continue to reinvest maturing bonds to maintain the size of the balance sheet.
Whereas changes in official interest rates indirectly impact markets and the economy via the cost of borrowing, changes in asset purchases and the size of the balance sheet can directly influence the amount of liquidity in financial markets.
Recall that quantitative easing works by the central bank purchasing assets from the private sector and pushing the previous holders of those assets to purchase other riskier assets such as corporate bonds or equities (compressing risk premia in those assts). When the process goes into reverse there is a greater supply of safe assets (Treasuries) enticing investors at the margin to sell down their riskier assets (and increasing risk premia in those assets).
The Fed says it wants to run down the balance sheet “in the background”, in a predictable manner, in an effort to avoid a repeat of the dislocations that occurred in markets in late 2018 and then again when repo rates spiked in September 2019. However, the balance sheet is significantly higher in US dollar terms and as a % of GDP now than in 2018.
Federal Reserve Balance Sheet
Source: FRED/Archive Capital
The conundrum for the Fed is it has two levers (official interest rates and the size of the balance sheet) to influence overall financial conditions with the objective of influencing economic variables such as demand, economic growth and inflation. There is significant uncertainty as to what combination of interest rates and balance sheet size would represent a neutral policy stance.
The Fed has already undershot significantly by keeping rates close to zero and continuing to purchase assets as inflation has risen. The risk is if the Fed adopts a policy of reacting more to the current incoming data it could overshoot, precipitate a hard landing for the economy and major dislocations in markets.
After two decades of gradualism and forward guidance, investors have been conditioned to expect incremental and well telegraphed policy changes from central bankers.
However, the Brainard principle of gradualism no longer holds if there is a risk that inflation expectations get unanchored.
A more aggressive reduction in policy accommodation could be justified by the unusual stimulatory stance of real rates and/or if inflations remains stubbornly high risking de-anchoring inflation expectations.
How the Fed treats the balance sheet is a big unknown this year. It is possible that the larger balance sheet is providing a stimulatory effect (keeping long term rates down).
The Fed may either have to raise rates more aggressively than expected or reduce the balance sheet more aggressively: both scenarios represent significant risks to markets and risk assets as we move through 2022.
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