The Fed has more work to do since policy is only moderately restrictive, but it’s likely to proceed cautiously, all rhetoric aside, given the high uncertainty about the economy. (ddp)

If you told investors then that the Fed would raise rates 450bps in less than a year, they’d be surprised—the market was pricing about 200bps of cumulative rate hikes in 2022 and 2023—but not completely shocked. The real shock is that after all those hikes the economy still isn’t in recession and is actually holding up reasonably well. Such economic resiliency begs the questions of why things aren’t worse, and how much more will the Fed have to hike in order to bring inflation down closer to the 2% target. These already difficult questions are further complicated by the financial stability risks created by the recent bank failures.

Rather than focus on whether the Fed will hike 25bps next Wednesday, it’s helpful to step back to assess what we’ve learned over the last year about the impact of monetary policy and the Fed’s policy intentions. Doing so provides perspective on the Fed’s possible path from here, barring more shocks to the financial system, which in turn informs the investment outlook. Here are some lessons learned.

First, the level at which rates become restrictive for economic growth is higher than was generally assumed. The Fed’s projection for the long-term neutral policy rate is 2.5%, a level that most investors would have agreed with until fairly recently. If that assumption was correct, then a policy rate of 4.5% should be quite restrictive for growth, but it hasn’t been so far. There are suggestions that in the short-term the neutral rate is higher, though how much is unclear. A simple rule is that the real Fed funds rate has to be at least positive in order to be restrictive. That threshold isn’t met when subtracting current CPI inflation (6%) from the Fed funds rate upper bound (4.75%). The real rate is modestly positive if the University of Michigan survey of consumer expectations for 1-year ahead inflation (3.9%) is subtracted instead. The critical point is that while no one knows with any certainty the long- or short term neutral policy rates, it’s reasonable to assume that current policy is not too restrictive.

Second, despite having raised rates 450bps, arguably the Fed hasn’t yet had to make a really hard decision on whether to continue hiking. Why? Because total nonfarm payrolls have increased 3.9m since the hikes began, the unemployment rate has stayed between 3.4% and 3.7% throughout the last year, and the overall data is consistent with a still tight labor market. In other words, the Fed has been able to focus exclusively on the price stability half of its dual mandate, with the full employment part being met. Until there’s evidence of rising labor market pain, the decision to hike while inflation is far above 2% shouldn’t be that difficult. A by-product of these relatively easy hiking decisions is that investors don’t yet know the Fed’s true threshold for inflicting economic pain while inflation is still above target.

Third, the length of the “long and variable lags” of monetary policy is uncertain, but it appears to be on the longer end of the spectrum in this cycle. Financial conditions have been a prominent part of the current lag debate. Proponents of this framework argue that tighter conditions are what slows the economy, and the negative growth impulse from a rapid tightening of conditions peaks in as few as two quarters. That means the largest negative impulse should be happening this quarter, yet growth appears to have re-accelerated. The argument for a shorter lag hinges on Fed forward guidance quickly depressing stock prices and lifting Treasury yields as they reflect expected rate hikes. But this transmission channel loses potency if the economy isn’t that sensitive to lower asset prices or higher bond yields. That may be the case this cycle because many households and business termed out their debt (e.g., locked in 30-year mortgages at 3%) before Fed hiking began. A higher 10-year yield wouldn’t have much impact on the spending of such consumers and companies. Consequently, this puts more onus on the policy rate, and corresponding floating interest rates, to slow the economy. Since the policy rate became mildly restrictive only recently, it’s not surprising that the economy has held up. Almost by default, that implies a particularly long lagged effect of rate hikes on growth, which will become more apparent in coming quarters.

Fourth, the unintended and unexpected consequences of rate hikes are a reminder that monetary policy tightening tends to have a nonlinear impact on the economy. This is a fancy way of saying that rate hikes are a blunt instrument for managing an economy and the environment can look fine until very quickly it doesn’t. Bank runs are a classic example of this phenomenon, in which a bank can be solvent and liquid one week and then out of business the next. This binary outcome of bank runs oversimplifies how the economy functions, but when the cumulative effect of tightening kicks in, the economy’s direction can turn quickly. This is not to suggest that a hard landing is inevitable, only that an economy that’s been surprisingly resilient could also deteriorate unexpectedly fast.

Fifth, while investors continue to debate whether Fed Chair Jay Powell will be remembered as Arthur Burns 2.0 more than Paul Volcker’s heir, the better template for understanding Powell and the Fed’s policy approach is Alan Greenspan, and in particular policy setting in the 1990s. This is a point we made one year ago when the hikes began, and the Fed’s actions since then have done nothing to alter this view. For starters, Volcker set a standard Powell hasn’t come close to matching—the Fed funds rate rose over 10 percentage points in six months in 1980. Matching that level of tightening in this cycle doesn’t appear to be necessary, nor economically beneficial when all the potential costs are considered.

Instead, the hiking cycle over the past year looks very similar to the 1994 cycle, during which Greenspan raised rates 300bps in 13 months, including three 50bps and one 75bps rate hikes. Greenspan also stopped hiking rates even as headline and core CPI rose above 3% in 1995. What he did do, with the benefit of hindsight, is take advantage of opportunistic disinflation. He kept policy relatively restrictive, at least based on a real Fed funds rates measured as the difference between the nominal rate and current CPI. That measure ranged between 2% and 4% from 1995 to 2000. Greenspan also adjusted the policy rate up and down twice during that span, responding to evolving conditions, including cutting rates in response to the LTCM / Russia crisis in 1998.

The bottom line: The totality of these lessons is that the Fed has more work to do since policy is only moderately restrictive, but it’s likely to proceed cautiously, all rhetoric aside, given the high uncertainty about the economy and nonlinear financial stability risks to its policy. The Fed is also likely to emphasize the longer part of the “higher for longer” mantra, keeping policy moderately restrictive while relying on opportunistic disinflation to get inflation back near 2%. This is the playbook that Greenspan deployed in the 1990s. With Powell already following the first year of the roadmap that began in 1994, it’s logical to assume that he’ll try to stay on the same path. The Powell Fed has already shown a willingness to fine-tune rates in response to changing economic conditions, as demonstrated by the rate cuts in 2019. Only time will tell whether Powell has the same success at engineering a soft landing as Greenspan did.

Main contributors: Jason Draho, Danny Kessler

Content is a product of the Chief Investment Office (CIO).

For more, see One year later , 16 March, 2023.