A Path of Prudent Policy
- Capital Risk
- Aug 10, 2024
- 7 min read
The Fed’s dual mandate of full employment and moderate inflation ensures conflict at turning points. The challenge for the Fed is to find the balance that ensures the long-sought “soft landing” of the economy. The “higher rates for longer” policy led to gradually lower inflation, while employment growth continued at a modest pace. The prolonged elevation of interest rates will ultimately lead to a slower economy and lower employment levels. The Fed’s policy path will determine the depth of the economic slowdown. The trouble arises with housing: dramatically lower interest rates in response to the Pandemic fed housing market prices. Excess housing demand over constrained supply drove housing prices and rents higher. The Fed faces the same risk as it seeks the timing for rate cuts: lower interest rates may again lift housing prices and limit disinflation. The prudent path is policy moderation.
Monetary stimulus brought unprecedented lows in mortgage interest rates and lifted housing prices, which continue to increase.
The Fed's challenge is that lower interest rates cure slowing employment. Unfortunately, high housing costs mean the cure for employment may reignite housing. Prudence dictates moderation for interest rate normalization.
A Decision point. The economy continues to hum along with all domestic sectors adding to growth (Exhibit 1). While imports continue to drag on growth, consumption, investment, and government are expanding. This strong growth situation gives the Fed confidence in its policy of higher rates as inflation moderates yet remains above target. The challenge for the Fed is to achieve the long-sought soft-landing of the economy where policy loosens in advance of employment losses, thus achieving its dual mandate of moderate inflation and full employment.
The trouble is that it’s not evident that achieving this virtuoso policy management is possible. The closest scenario to this outcome was the technology bubble in 2000, which saw a minimal decline in gross domestic product yet a moderate loss in employment as the technology bubble reallocated labor. The difference now is that there is no apparent stock bubble to unwind (artificial intelligence notwithstanding) with high interest rates. This time, inflation is of the more nefarious type that directly impacts consumer spending, not how they invest excess savings. While prolonged high rates drive inflation downward, they may lead to an impairment of employment, thus a conundrum for the Fed.
Exhibit 1. GDP Contribution by Component
Deflating Inflation. The pandemic caused a surge of inflation not seen for nearly forty years (Exhibit 2). The initial debate was on the timing of its remediation: some were on the side of transitory inflation that would not seep into wider and more secular inflation. With inflation running above the Fed target over three years, it would seem evident that the transitory side was misguided in its prognosis. Indeed, it seems likely that inflation will return to the two percent threshold in about a year at the current deceleration rate. This outcome would deliver five years of above-target inflation, suggesting some degree of permanence.
Exhibit 2. Consumer Price Index (CPI) and CPI ex Food & Energy (Annual Change, %)
This inflation period would, however, be three years shorter than the 1991 to 1998 period, when core inflation rose and then slowly declined to two percent. Of course, the difference at that time was the higher level of trend inflation, which was closer to four percent than two percent. Yet, the rise of inflation from breaching two percent to its peak occurred over thirty months (March 2020 to September 2022), so deflating over a similar period would seem the most likely outcome. This trajectory is playing out and gives the Fed leeway to switch focus to employment. As with inflation forecasting, timing is critical to policy.
The Reality of Rules. It is said that rules are meant to be broken. Yet monetary policy requires prudence. The Sahm Rule states that a recession begins when unemployment's three-month moving average (MA3) increases by more than 0.5 percent above its 12-month MA3 low.[1] Currently, the number is 0.4, merely 0.1 below the threshold that signifies a recession’s start. Given the trend of +0.1 over the prior five months, it would only take the next two months of that rate to reach the definition. Thus, a recession could occur if the past is a prelude.
The Sahm Rule is intuitively appealing for determining when a recession begins. A large jump in unemployment over a short period would suggest a dramatic reversal in the employment situation. Yet, two critiques arise. First, market technicians and data miners know the peril of fitting past data since informationally complex data always offer an ex-post explanation. Second, the Pandemic’s large upheaval of employment, shifting people from services to goods and back, may suggest frictional rather than structural unemployment.
Exhibit 3. Sahm Rule of Recession
Source: U.S. Bureau of Labor Statistics, retrieved from FRED, Federal Reserve Bank of St. Louis.
An Inverted Precedent. The criticality of monetary policy to the economy is indisputable. The cost of money drives investment and savings decisions. A bank’s net interest margin (i.e., profit) depends on the interest rate level, where they borrow short-term and lend long-term. This dynamic is enabled when short-term interest rates are lower than longer-term interest rates (i.e., an upward-sloping yield curve), which permits banks to pay less for deposits (i.e., borrow money) than they receive on loan payments (i.e., auto loans). Thus, changes in the shape of the yield curve can portend a recession.
Exhibit 4. Yield Curve Slope (3-Month minus 10-Year)
A much-followed heuristic is the yield curve's slope (e.g., 10-year yield minus 3-month yield), which shows when short-term money is expensive (Exhibit 4). Historically, an inverted curve (e.g., a negative curve) delivered a recession within a year. Yet, this infallible measure was inverted in the third quarter of 2022 without a recession arriving two years later. The outcome provides context for the Sahm rule: a coherent economic argument supported by historical data does not provide future certainty. Some of the most expensive words in finance are “it’s different this time.” Yet, it is a helpful reminder that informationally complex data requires pragmatism rather than dogmatism.
Labooring Employment. The Fed’s battle against inflation is nearing an end as the growth rate returns to target. Yet, the Fed has a dual mandate: inflation and employment.[2] This dynamic ensures that the monetary policy will focus on two moving targets. Since the Pandemic, employment grew briskly as the dislocations that occurred were reversed. Yet, the most recent numbers show a notable deceleration in the employment situation (Exhibit 5). Some prognostics argue that employment data should compel the Fed to cut rates soon to avoid employment decline.
Exhibit 5. Non-Farm Payroll Employment (000) with a Three-Month Moving Average
The Fed's challenge is that these growth rates are not materially different from the mean rates (140K) that occurred 50 years before the Pandemic. Certainly, the labor force is larger, yet the prime-age labor force stopped growing in 2020. 3 The implication is that this level of employment growth may reflect the current workforce composition, which has implications for monetary policy. Cutting rates when employment is strong may reignite inflation.
Rate Neutrality. Monetary policy intends to manage the flow of savings and investment in the economy. A lower rate encourages more investment, while a higher rate encourages more savings. Viewing the economy as the output of total investment (i.e., the total diversified portfolio), an incentive exists to borrow money and invest when borrowing rates are below this output rate.[3] When the Fed talks of the natural rate, they reference some version of this concept. The challenge for the Fed is that policy remains stimulative.
Exhibit 6. Nominal GDP Growth (%) Minus Fed Fund Effective Rate (%)
The Fed increased the Fed Funds rates materially in a short period. Historically, a change of rates at this speed and magnitude led to a recession, yet not this time. The reason is that the Fed Funds rate is still stimulative (Exhibit 6). For the Fed to begin cutting rates, it must believe that growth or inflation will slow further. While inflation continues to decline further, housing costs are the main laggard and the one that lower rates will greatly enhance. Thus, cutting rates could impede a further slowing of inflation.
A Question of Quantity. The Fed knows the dangers of cutting too soon: the 1970s are not so distant that the lessons are forgotten. The debate is about when and the amount. With current policy only modestly stimulative and inflation slowing, a rate reduction could align policy with future economic conditions. This is particularly true when monetary policy implementation takes time to work through the economy. Yet, precedent indicates another path (Exhibit 7). The Fed usually responds with material rate reductions before an economic slowdown.
Exhibit 7. Fed Funds Effective Rate (%)
Herein lies the Fed's quandary. Inflation is trending towards target, and employment is slowing. Yet, current employment levels are consistent with average growth and not indicative of a recession. Thus, the prudent path for the Fed is to reduce the rate consistent with the inflation reduction until new employment data indicates otherwise. The Fed has consistently stated that it is data-dependent in its policy decisions. The current situation does not indicate otherwise. A large initial cut would indicate economic weakness, which would cause unease. The prudent path indicates a modest rate reduction to align with the neutral rate until employment indicates otherwise.
This excerpt is the macro view of the US Economic Outlook 24Q2. Read more here.
[1] A more fulsome discussion can be found at https://en.wikipedia.org/wiki/Sahm_rule
[2] The U.S. Federal Reserve is the only monetary authority in the developed world that is subject to a dual mandate. The others primary mandate is inflation, then a secondary mandate of employment.
[3] The total economy is viewed as the complete portfolio with risk fully diversified. Thus, this yield can proxy for the risk-free (i.e., minimizing) rate.
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