The Federal Reserve is being extremely slow and careful as it prepares to normalize its monetary policy. This caution in hardening makes it seem like any misstep could be dangerous. However, from Bank of America (BofA), its global economist, Ethan Harris, points out that history shows that the economy and markets can withstand a well-choreographed tightening cycle, despite the fact that their current “zerophobia” – fear of abandoning zero rates – seems to indicate otherwise.
In this sense, he insists, in a report published and distributed this week, that it is important to put the next cycle of rate hikes in perspective. As he explains, at the moment, the bond market expects a very flat tightening cycle (around 150 basis points by the end of 2023). Even the somewhat more aggressive projection they shuffle from BofA is much slower than normal.
Harris estimates that since the bond market anticipates a mild tightening cycle, it should not be affected if the Federal Reserve is limited to “administering the expected medicine.” Of course, as he mentions, perhaps the stock market is more accommodating and implicitly discounted an even flatter trajectory. But even if this were the case, a correction in the stock market would not have much of an impact on the economy after a bullish boom as long as the one experienced recently.
The lag between the first rise and the recession ranges from 39 to 86 months
The US economy has performed well during the early phases of the Fed’s rate hike cycles. In the last cycle, the central bank began raising rates very slowly, instigating the first 25 basis point hike in December 2015. , but it did not rise again until a year later.
During the next two years they increased once a quarter, except for a pause in the third quarter of 2017, when they began to reduce their balance sheet. The Fed stood by in early 2019 and then cut rates to 1.75%. According to some opinions, this showed that the economy could not support rates above 1.75%. In fact, this seems to be a common narrative in the bond market.
Still, the Bank of America economist points out that even with a funds rate of 1.75%, the EUUU economy was strong before the covid crisis. For example, payroll job growth slowed in early 2019, but in the six months leading up to the pandemic, it amassed an average of 236,000 a month.
A similar story is valid for the previous cycles. Recessions have always come long after the start of tightening cycles, and other shocks typically play a role in recessions. The 1990 recession was due in part to the savings crisis, the 2000 recession to the bursting of the tech bubble, and the 2008 recession to the collapse of credit markets. In 1995, the tightening did not cause a recession. The lag between the first rise and the recession ranges from 39 to 86 months.
This does not mean that a gradual normalization by the Fed has no consequences.
History also holds that tapering (that is, the reduction in asset purchases) and the reduction of the Fed’s balance sheet are not as dangerous processes as some experts suggest. In 2013, the idea of tapering was the subject of a huge tantrum. One of the favorite charts of the time showed the correlation between the Fed’s balance sheet and the S&P 500. Experts argued that the market was, in effect, “addicted” to the central bank’s asset purchases and would suffer when the central bank broke. withdraw. A similar concern arose when the Fed began to shrink its balance sheet in 2017. For Harris, this argument is overblown. In neither case was there an impact on the equity bull market. Nor did they stop the steady decline in the unemployment rate.
“This does not mean that a gradual normalization by the Fed has no consequences,” he warns. Harris mentions Bank of America strategist Savita Subramanian and her team expecting the stock market to flatten over the next year, in part because of gradual Fed rate hikes. The BofA economist sees a gradual slowdown. growth over the course of the next year, again in part because the Fed shifts from a super-accommodative to a less accommodative policy. However, none of this justifies keeping the federal funds rate close to zero, as is the case today.
Morgan Stanley reinforces bearish stance
For its part, Morgan Stanley redoubles its pessimism. Michael Wilson, its chief strategist, warns that “the Fed’s shift to a more aggressive tapering schedule poses a greater risk to asset prices than most investors realize.”
In this regard, Wilson also reveals how the Fed’s new tightening policy is endorsed by a Biden Administration that seems less focused on the stock market as a barometer of its success. The Morgan Stanley strategist believes that this time the purchasing cut-off process will be different from that of 2014 for 3 reasons.
First of all, the reduction is being twice as fast as at that time. Second, asset prices are much higher, and finally, economic growth is on the way to slowing rather than accelerating.
Greater uncertainty on the horizon is one of the key elements for the bank to estimate that US equity market valuations are likely to decline “in the next 3-6 months.”
Powell’s arsenal of contradictions undermines the credibility of the Fed
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