In defense of the Fed’s rate hike campaign
Though I have been on recession watch for nearly all of 2016, I want to write this post as a reminder that there are upside scenarios for the US and global economy. The Federal Reserve looked forward and felt it could tighten into a slowing economy and rising dollar without the economy falling into recession. And so far, they have proved correct. Thinking of this business cycle in comparison to the last two, let me outline my thinking on what are upside scenarios here.
Back in August, I wrote that, “when I look at the data coming out of the US on GDP growth, jobless claims, retail sales, non-farm payrolls, or what have you, all of it says the economic recovery will continue for the foreseeable future. None of it points to imminent recession. And in fact, if you look at the recent housing data, it points more to a mid-cycle pause than the end of cycle dynamics I tend to believe are at work.” And because those sentiments are still true today three months later, I think it makes sense to think about what an expansion with rising interest rates would look like. And the two previous cycles come to mind.
We are in the seventh year of an economic upturn, a time frame that would roughly correspond to 1998 or 2008. In both of these business cycles, the Fed had begun raising interest rates sooner in the cycle. In the 1990s, it was in 1994. And the precipitous rise of rates almost caused a recession. But once the hike campaign ended in 1995, the economy continued recession free for another six years. During the last business cycle, the rate hikes began in 2004 and were more steady, but the campaign was much longer, taking us well into 2006, when the housing market was already falling apart. Recession came 18 months later.
When I think about the ability of the economy to absorb rate hike shocks, I first think of the cyclical components that lead to a garden variety downturn – inventory purges, capital investment declines that are large enough to presage layoffs and consumer retrenchment that creates recession. But I also think about financial excess like the kind we saw during the tech bubble and the housing bubble. This cycle, we have largely survived the implosion of an oil sector capex ‘bubble’. The other areas of potential credit froth like residential real estate, corporate real estate, student loans, and auto loans are not at points in their cycles where one or two hikes would create exhaustion.
Moreover, there are two further reasons to be optimistic. First, the private sector is a net receiver of interest. If interest rate hikes don’t have negative consequences on agents of cyclical turning points in the economy nor on the financial economy through credit, the net receipt of interest income becomes the dominant factor. In that sense, one could argue that rate increases could be a net positive for growth in a healthy mid-cycle economy
Second, there is no empirical evidence that capital spending and interest rates are connected in a cause-effect chain.
— Edward Harrison (@edwardnh)
It could well be the case that capital spending is mostly driven by the perceived profitability of that spending and that investment profitability is not heavily determined by the level of interest rates. We don’t know if that’s true, but we also don’t know if an increase in rates will have a material effect on capital spending since there is no evidence that it has done.
I believe that the scenario that is playing out now has become similar to the 1994-95 hike campaign that fostered a strong US dollar and eventually led to the Asian crisis two years later. Because the size of Asian economies was so small and the US economy is relatively insulated from abroad due to a low GDP-percentage of trade flows, the US continued to prosper. We have no assurances the same will happen now.
And therefore I am now more attuned to so-called ‘bubbles’ than I am to recession risk. This past weekend, I was at a cocktail party in the New Jersey suburbs of Philadelphia and was struck by the conversation I had with two guys who are in the commercial real estate business. They were incredibly bullish on CRE. There was no hint in anything they said which would suggest they believed the CRE uptrend was coming to an end anytime soon. And while I am not as plugged into CRE this cycle as I was residential last cycle, it does concern me when I hear blind optimism about a sector which has already seen a massive move higher. It makes me think that the sector would be vulnerable to a major retrenchment at the end of the business cycle as participants get caught out.
As I have repeated all year, the US economy is not in a recession or even close to a recession. But I take an optimistic view on the trajectory these days. Overall, while I don’t think the US economy is at or close to full employment given how high the U-6 level of unemployment is, I don’t think this means a Fed rate hike campaign will doom the US economy. Instead, you could defend the Fed’s action as an avenue by which the private sector can begin to accumulate interest income. What we need to be watching more than recession signals now is for signs of credit excess that would make the US economy vulnerable. And we also need to be watching how the bull market in the US dollar plays out on the global stage.