The most recent US tightening cycle was more aggressive than it appears
How aggressive was the Federal Reserve’s most recent hiking cycle?
Take the end rate minus the beginning rate, and the upper limit of the Federal Funds rate jumped 225 basis points (bps) to 2.5% from 0.25%. This is nothing special when compared with prior cycles and actually looks relatively mild.
If, however, you view it in terms of the percent change between the beginning rate and the peak rate, the Federal Reserve (Fed) increased rates by 900% in only 37 months. This dwarfs any other cycle in terms of aggressiveness. In the cycle prior to the 2008 credit crisis, the increase was over 50% less than this.
Compounding this is the fact that the Fed was simultaneously reducing the size of its balance sheet, which also serves to tighten financial conditions, at a rate of about $50 billion per month. The balance sheet was reduced by about 16%, to $3.8 trillion from $4.5 trillion as of the first hike in 2016.
This substantial increase in rates and large reduction in the balance sheet came after a prolonged period of unprecedented policy support. The initial rate hike marked the end of an 85-month period where the policy rate was held at a record low of 0.25%.
It also came after the Fed’s decade-long quantitative easing (QE) program, which drove the Fed’s total assets to a record high of over $4 trillion. This extended period of loose monetary policy prior to tightening also dwarfs any other previous cycle by a wide margin in both duration and magnitude. The longer QE and low interest rates remain in place, the more the market becomes accustomed to easy money. More cheap financing will have been extended and more risks will have been taken.
Based on this information, we see that monetary policy had been historically easy on both a relative and absolute basis for an extraordinary amount of time and that rates were subsequently increased by a record amount in a very short window. Meanwhile, the Fed was attempting to trim an unprecedented amount of assets from its balance sheet following 10 years of extensive asset purchases, a maneuver never before executed in the US while simultaneously hiking rates.
Financial markets woke up to this in 4Q18, which proved to be a difficult period for risk assets. The VIX, an index measuring forward-looking volatility expectations, spiked to over 35, the S&P 500 fell over 20% from peak to trough and high yield spreads widened by over 210 basis points (bps). A key recession indicator started flashing red, as the spread between the 10-year US Treasury and the 2-year US Treasury moved sharply lower and ultimately inverted. The spread between the 2-year and 3-month US Treasuries also inverted, indicating fears of a recession.
What does this mean and why does it matter?
Given all of this, a “soft landing” for the US economy, a moderate slowdown in activity and avoidance of recession, would be a decidedly good outcome. While there is precedent for the Fed extending an economic cycle after overtightening by delivering “insurance cuts”, like in 1995 and 1998, never before has the Fed used this maneuver in an environment where rates were cut so aggressively while the balance sheet was being trimmed by such a large magnitude.
Loose lending standards serve to boost the economy through a number of channels, encouraging borrowing by businesses, individuals and governments, while discouraging saving and encouraging spending. When these conditions change - as the Fed tightens their policy rate and money is no longer cheap - the shock can lead to a contraction in economic output. This is because spending sharply decreases, and it can potentially lead to a recession. The risk of a sharp contraction and recession is inevitably higher if rates rise sharply and by a significant magnitude, especially after a prolonged period of low rates.
On top of this, unlike any other cycle, there was an additional force that was contributing to sharply tighter financial conditions. Never before has the Fed been unwinding billions of dollars in assets per month from their balance sheet while simultaneously hiking rates so quickly. As the Fed reduces their balance sheet, liquidity is drained from the financial system as the money supply drops, volatility can increase as the programmatic buying of low-risk securities ceases and borrowing becomes more expensive as yields begin to rise.
Using prior recessions as a reference, it is difficult for the economy to maintain momentum when financial conditions are tightened too rapidly. While there were other factors at play culminating in the financial crisis of 2008, Bernanke’s Fed certainly played a role.
In hindsight, rapid tightening after a period of loose policy damaged confidence and the spending outlook. It drove mortgage rates sharply higher, something the housing market was ultimately unable to handle, given the substantial expansion in mortgage debt. Other past recessions too have been in part caused by a policy misstep by the Fed that inverted the yield curve and damaged output. Yield curve inversion, a phenomenon that is almost always explained by a Fed policy mistake, has preceded every recession in the US over the past 50 years.
Even the Fed chair, Jerome Powell, recently shifted his rhetoric to acknowledge that policy rates may have been excessively tightened given the macro-economic backdrop. In a recent speech, Powell cited revisions to past job gains figures to convey that the economy was likely weaker than previously thought at the time of the rate hikes.
Additionally, he said that the Fed’s view of the neutral rate of interest - the level that is neither accommodative nor restrictive to the economy - was likely too aggressive at the time of the cuts, and that policy rates were likely more restrictive than previously thought. Estimates for this neutral level have declined steadily over recent years, helping to explain the Fed’s rapid pivot from a hawkish stance to a dovish one.
This time may be different: US headed for soft landing?
If recent data is any indication, however, this time may be different. The seemingly unlikely outcome of a soft-landing appears possible. The consumer has held strong over previous quarters, helping keep GDP growth at 2% or more over the past two quarters.
Currently, the consensus is for US growth to bottom out at about 1.7% in 2020 before rebounding. While this is certainly below trend growth, it is a far cry from the imminent recession that appeared to be priced in 4Q18. The US economy is not out of the woods yet, but there are some signs that manufacturing activity is stabilizing, that the services sector is holding strong and that the consumer is healthy as we move into the key holiday season.
One of the major drivers of manufacturing weakness appears to be trending positively, as the US-China are potentially on the verge of a phase one deal on trade that would largely cap the downside in terms of further escalation. Additionally, the Fed, along with many other global central banks, has reversed course by cutting rates and by beginning to re-inflate the balance sheet. Much of this easing will impact the economy with a lag, so it is highly unlikely that the global economy has experienced its full effect as yet.
Even if growth picks up modestly from here, the Fed is likely to remain on hold. In prior periods where “insurance cuts” were delivered, policy rates remained unchanged for an extended period of time following the final cut. Inflation would likely need to rise materially for the Fed to act. There is also reason to believe that the Fed is much closer to the neutral rate than it appears.
In the previous cycle, the neutral interest rate was about 4%. For various reasons, including the lingering effects of the 2008 financial crisis, limited growth in the labor force, the aging population and the lack of productivity gains, the rate considered to be neither too stimulative, causing the economy to overheat, or restrictive, causing contraction, is now closer to 2%-2.5%. This means the Fed is not as far away from neutral as it may appear at first glance, and that there is likely more room for them to remain on hold in the case of an economic rebound.
Only time will tell if the US economy will be able to weather the historic level of tightening that occurred in the most recent hiking cycle. What is certain, however, is that the Fed will be in no hurry to tighten policy rates as aggressively next time around.