Monetary policy — the Fed is still tidying up from 2008, but policy remains supportive
If we envisioned a 10-year-old economic recovery, with below-trend unemployment, above-trend growth and inflation in line to slightly below target, what should the stance of monetary policy be? In such a case, inflation is not a problem and thus does not require the Fed to actively constrain monetary policy to battle inflation. But nor would such an economy require monetary policy stimulus. The net result would be a prescription for roughly neutral policy — one neither seeking to constrain inflation, nor promote growth.
Today we find ourselves in an environment where, despite the continued withdrawal of stimulus in the form of four rate hikes in 2018 and the continued wind-down of the Fed balance sheet, overall policy remains accommodative. The balance sheet remains elevated in both size and profile as the holdings continue to include agency mortgage-backed securities and longer-maturity Treasuries. These holdings were not part of the equation prior to the crisis. Recently the Fed has intimated a larger terminal balance for the balance sheet, but that terminal point is still below current levels. We know this since the Fed is permitting the balance sheet run-off to continue.
The Fed Funds rate is closer to neutral than the balance sheets in our view. “Neutral” is a somewhat tricky target as it is only known fully in retrospect. However, in our view, the targeted rate remains slightly below what will be viewed in retrospect as the neutral rate. We therefore see the potential for an additional one to two rate hikes in the current cycle if data remains supportive, acknowledging that a government shutdown, and again-patient fed, may extend the timeline.
If our view is correct, monetary policy will continue to be a net support to the economy in 2019 albeit a less dramatic factor than years passed. Any concerns of the Fed over tightening should be kept in the context of a central bank on the accommodative side of neutral in a landscape that generally speaking should call for neutral policy. At the same time, being closer to neutral and the lack of inflationary pressures allows the Fed to continue carefully calibrating each next step as opposed to acting out of need.
The gems you find when you clean up
Monetary policy tightening, if not yet tight in our view, has been held up as a possible cause for the next recession. In the recent American Economic Association’s annual meeting, which featured a conversation with current Fed Chairman Powell and his two predecessors Chair Yellen and Chairman Bernanke, this question was addressed. Chair Yellen reiterated her belief that “I don’t think that expansions just die of old age. Two things usually end them. One is financial imbalances and the other is the Fed.” In discussing the role of the Fed, she highlighted that monetary tightening that ended expansions was typically in response to increasing inflation — a variable noticeably absent in today’s environment.
The other variable that has been inextricably linked to recent recessions, in addition to the Fed going too far in tightening policy, is a spike in oil prices. A paper presented to the Fed in 2014 “The Role of Oil Price Shocks in Causing U.S. Recessions,” noted that “It has proved difficult historically to separate the role of these two explanations of the business cycle because most recessions are preceded both by higher oil prices and by a tightening of monetary policy and/or of credit markets. One would have expected that over time a recession would have occurred that is unambiguously associated with one explanation only, resolving this identification problem. This has not been the case.” Though somewhat forgotten amidst the turmoil of the global financial crisis, that period too, was preceded by a spike in oil prices to $140/barrel.
While it is difficult to say that a recession could not occur without a rapid increase in oil prices, it is fair to say that in the U.S. it has not. Interestingly, while concerns persist of the Fed going too far too fast, at the current juncture oil is still meaningfully below recent peaks. If a recession were to occur now it would defy this pattern and offer the Fed researchers the case study they are seeking. While not dispositive, this history supports our expectation of more length to the current cycle.
Corporate debt — are companies hoarding?
Much has been made of the increasing levels of debt since the 2008 crisis. But has this been a healthy re-leveraging after a shock deleveraging or a dangerous repeat of the catalyst for the past downturn? We addressed the health of the consumer in “What if the Joneses are fiscally responsible neighbors”; (spoiler alert: the consumer is healthy). But how is the corporate sector?
Proving Sun-Tzu’s axiom that generals always fight the last war, recent headlines have focused on leverage in the corporate sector as a source of trouble, for example:
- “The Big, Dangerous Bubble in Corporate Debt” — New York Times, August 9, 2018
- “The U.S. is Experiencing a Dangerous Corporate Debt Bubble” — Forbes, August 29, 2018
- “$9 trillion corporate debt bomb is ‘bubbling’ in the U.S. economy” — CNBC, November 21, 2018
By nominal measures such as outright debt levels or even adjusted measures such as corporate debt to GDP, corporate debt figures are high in a historical context. However, debt service ratios, which account for the low cost of debt, show corporate debt almost exactly in line with historical debt levels.
Increasing nominal debt in a period of low interest rates to the point where debt service matches that of prior periods seems like a textbook response to a low rate environment.