The Fed’s overtightening and the shift to a fiscal paradigm

The Fed’s discomfort

For the better part of 4 years, I have been telling you that the Federal Reserve has been uncomfortable with a mid-cycle role which required it to keep rates at zero percent. The Fed sees its role as principally reserved for cycle turns and not as an agent of mid-cycle stimulus. Both Chairs Bernanke and Yellen expressed discomfort with their increased mid-cycle role, fearing – rightly – that it would make the Fed a target of political intrigue.

As I put it two years ago, the Fed has been and probably will be more hawkish than you think. This is important in terms of understanding the Fed’s overtightening, and why it is now behind the curve. But I think we are near an inflection point where the Fed’s efforts to normalize policy produce an irredeemable policy error – tipping the US economy into recession in 2020. In fact, that’s been my base case now for three or four months. So I am putting this piece together to lay out the narrative that makes most sense in that context.

Jerome Powell’s comments yesterday about how well the US economy is doing make clear the Fed is not in full easing mode here. He certainly has hawkish dissent from the likes of Esther George and Eric Rosengren plus, next year, Loretta Mester. And I reckon he wants to cut a path between those hawks and the dovish members like Jim Bullard and Neel Kaskari which will garner a better medium-term consensus policy path. That makes communication difficult, particularly as we are near a potential inflection point between a garden-variety mid-cycle slowdown and recession which requires particular attention from monetary policymakers.

The Fed’s normalization

Normalization began with the taper of large scale asset purchases under Ben Bernanke. Even then, the markets dislocated on the news, resulting in the Taper Tantrum of 2013. But, ultimately the Fed was successful in weaning the economy off of Quantitative Easing.

When QE was done. The next move away from mid-cycle Fed dependence was in ‘normalizing’ policy rates. In retrospect, there were multiple rationales for normalization — from the need to ‘reload the monetary gun’ to the desire to tighten financial conditions and prevent a bubble from forming. But, there was a consensus in the Fed that rates needed to go up. Starting with the Yellen Fed, we saw a successful gambit, then, to further move away from the mid-cycle stimulus regime, with bond markets getting dragged the whole way to 2.5% under Powell.

Now, let’s remember that the Fed started 2018 saying it would hike three times, with the markets pricing in two hikes or less. Even then, anyone watching the Fed should have realized that four hikes were more likely than two. But it wasn’t until March – and after the whole bond bear market talk and volatility spike – that this became apparent.

The Boston Fed’s Eric Rosengren is an important character in this respect. I flagged his comments in March 2018 as “prepping [the] market for [an] accelerated timetable.” And, in retrospect, we should see this as the point in which Rosengren flipped from dove to hawk. He is now leading the charge in resisting the market’s desire for more Fed accommodation. In that sense, he is emblematic of the Fed’s continued hawkishness relative to the market’s positioning.

By October, Powell and Fed Governor Lael Brainard began talking about not just a fourth hike in 2018. They began suggesting the Fed was well below a ‘neutral’ fed funds rate, meaning more acceleration in 2019 or 2020 was coming. And the Fed did end up hiking four times in 2018, the extra hike coming in December.

The Powell Pivot

But, under Powell the Fed has been forced to backpedal. The December 2018 rate hike was a policy error. And the Fed has been under intense criticism for getting it wrong.

A lot of people forget that Yellen hiked in December 2014 and backed off during the subsequent mid-cycle slowdown. The takeaway inside the Fed was that, although the December 2014 hike may have been a policy error, the Fed was successful – by not hiking in 2015 – in adjusting policy and preventing recession.

So, the Fed’s likely thinking now is that they can do the same today as they did in 2015 i.e. reversing course and preventing recession. They have even cut this time, which ostensibly means they are being more accommodative today than they were in 2015 when they just stood pat.

This would explain Powell’s comments about the health of the US economy in the face of a big downdraft in both manufacturing and services data sets. To say, “The US economy is doing fine and the jobs picture is good” as I did when presenting the data is to mirror the Fed’s thinking.

But, of course, I think this is a mistake in reading the data. Rate of change numbers are universally bad right now. And the Fed should not be resisting the trend down in rates. My view is that the Fed risks causing the next recession by resisting too long at a particularly vulnerable point in the cycle – and then getting blamed for it.

So, my read is that the Powell Pivot is not as aggressive as it has needed to be. And the downside risks now outweigh the upside opportunity in the US economy. Let’s see where this heads as 2019 winds down.

The fiscal shift

Irrespective of how this plays out, I think that the shift away from mid-cycle monetary support is well advanced. And that means that, at least at the margin, we are moving toward a more pro-fiscal policy paradigm, both in North America and in Europe. I see a lot of people talking about this shift, with an increase in inflation and inflation expectations as the obvious medium-term outcome.

The real question is whether this shift happens in a recessionary environment or in one of mid-cycle slowdown. If the die is already cast and monetary and fiscal support is too little, too late, that’s a very different market, economic, and political world than one in which we move up and to the right.

Going forward, there are two things to watch then. One is the degree to which recession signs are lurking or a bottoming is setting in. For example, I see nothing in the jobless claims data released today, where year-over-year trends are benign to neutral. But, we should also be watching for how aggressively the trend toward fiscal support gathers steam because this will be crucial in understanding the market, economic and political outcomes, perhaps for years to come.

If the policy shift is too late, the eventual shift will be more aggressive and more populist. If it comes in time or if the cycle simply doesn’t need it to upshift yet again, we will continue on the same path for a few more years. Personally, I think 2020 is going to be a big year in historical terms. Be ready.