Tightening monetary policy: when does it get too much?

er-patrick

Patrick Er

 

Introduction

The US Federal Reserve (Fed) has now raised rates to 2.5% amidst increased market volatility as investors worry about the prospect for global growth. Since the 1970s1, all six main Fed tightening episodes ‘caused’ some market dislocation but only four preceded recessions. So, when does tightening get too much for the economy?

Tighter monetary conditions raise borrowing costs and impede spending, but there are also benefits from higher interest incomes, and policy tightening usually occurs in more robust economic climates, when businesses and households tend to be in better shape. It seems there is a balance to respect, and that over-tightening can tip the scales to a crisis episode.

Therefore, it is useful to have a set of broad guidelines on what to look out for during a sustained Fed tightening phase to help assess the risk of a significant economic slowdown or recession and its potential severity.

How to tell if the Fed has over-tightened: broad guidelines from history

Chart 1 shows that since 1976 there have been six major Fed tightening phases, with a recession of varying severity following four of them. Interestingly all six phases preceded market dislocations, locally, internationally or a combination of both (Chart 2 shows major foreign dislocations). This was the case even during the ‘benign’ tightening phases where no US recession occurred.

Chart 1: US Fed funds rate, inflation and recessions

US Fed funds rate, inflation, and recessions chart

Source: Macquarie and US Federal Reserve, November 2018

Chart 2: US Fed funds rate, and major foreign market dislocation

US Feds funds rate, and major foreign market dislocations chart

Source: Macquarie and US Federal Reserve, November 2018

So what determines whether tightening episodes are ‘severe’ or ‘benign’?

One response is “when interest rates get too high!” But this begs the question of what is considered “too high”. The 1983/84 tightening phase reached levels far higher than the 2004/06 phase, and yet only the latter ‘caused’ a recession.

The length of time in hiking interest rates also does not suggest a consistent pattern. The 1993/94 phase was longer than the 1999/2000 phase, but only the latter preceded a recession.

The level of interest rates and how long it takes to get there matters, but we find something more concrete is needed to guide decisions.

1. When Fed fund rates exceed inflation, significantly…

A clearer pattern is observed when inflation is taken into account.

You will notice in Table 1 below, that most recessions since 19802 occurred when the Fed hiked rates to levels significantly above inflation. There were two episodes – 1983/84 and 1993/94 – where Fed funds rates were well above inflation, and no recession or crisis of note followed. But neither episode was also met with rates close to prior cyclical peaks. We believe this may be because, all things being equal, the economy had adjusted to the higher interest rate conditions, and to bring about a greater economic response, the Fed would have had to hike rates closer to the previous peak.

Therefore, one sign of policy over-tightening, in our view, is when the Fed hikes rates significantly above inflation, for a period of time, to levels close to or above the previous cyclical peak (see Table 1).

Table 1: Fed monetary policy tightening phases and economic cycle

Fed monetary policy tightening phases Difference from previous cycle peak (%) Outcome
1978-1981 + 9 Recession
1983-1984 - 8 No recession
1987-1989 - 0.7 Recession
1994-1995 - 5 No recession
1999-2000 - 1 Recession
2004-2006 - 1 Recession
Current from 2015 - 3.25 No recession...yet!

Source: Macquarie and US Federal Reserve, November 2018

2. ... and this can be affirmed by a yield curve inversion

A complementary indicator to affirm the above rule of thumb would also be helpful. A familiar one is the yield curve, as depicted by the spread between long and short-term Treasury bond yields.

We find this indicator has been a fairly accurate signal of recessions. In our view, Chart 3 below shows whenever the Fed hikes rates to where the 10-year Treasury bond rate falls below the three month Treasury bill rate i.e., the yield curve inverts, a recession soon follows.

So, if Fed rates go significantly above inflation to levels close to the previous cycle’s peak, and if the yield curve inverts, an over-tightening becomes more likely in our view.

Chart 3: US Fed funds rate, inflation, and yield curve inversion

US Fed funds rate, inflation, and yield curve inversion chart

Source: Macquarie and US Federal Reserve, November 2018

Remain aware of the prevailing extent of private indebtedness

In applying the rough rules of thumb to guide decisions, we can sometimes forget there are structural economic relationships underpinning them.

For example, if the Fed were to over-tighten, a recession occurs not mechanically, but because fundamental economic behaviour has been altered to give such outcomes. Therefore, an awareness of these underlying economic conditions is important, and one particularly key condition is the prevailing degree of indebtedness (debt to income).

To be precise, the severity of recession due to a Fed policy over-tightening depends on how heavily indebted households and businesses are. The extent of over-tightening need not be large before a recession and/or financial crisis hits if the debt burden is extreme. We believe that is why, by historical standards, the extent of over-tightening during the 2004/06 episode was not particularly great, but a severe credit crisis erupted because household leverage was so extreme (see Chart 4).

Therefore, in applying the rules of thumb here, we should also be aware of the existing state of household and business indebtedness.

Chart 4: US Fed funds rate, inflation, and household indebtedness

US Fed funds rate, inflation, and household indebtedness chart

Source: Macquarie and US Federal Reserve, November 2018

Conclusion

Based on historical standards, a broad set of guidelines to help assess whether the Fed has over-tightened monetary policy is if:

  • the Fed funds rate exceeds inflation significantly for a sustained period (at least a year)
  • the interest rate level reached is close to or exceeds the previous cyclical peak
  • the yield curve inverts

The extent of household and business leverage adds to the pressures caused by over-tightening, and escalates the severity of outcomes.

Based on these simple guidelines, how should the current Fed tightening phase, on-going for more than three years now, be viewed?

A visual evaluation (see Chart 1 above) shows the Fed funds rate has now converged with the inflation rate. However, the Fed funds rate is nowhere near levels reached during previous cyclical peaks, and while the yield curve is flattening, there is still some way to an inversion.

Therefore, to us, the current Fed rate hiking phase does not imply over-tightening…yet. This however, does not mean that adverse temporary market reactions will not happen. Remember, all sustained Fed tightening phases cause some degree of financial market dislocation. Increased market volatility in 2018 reinforces that point.

This implies a need to put in place a strategy that seeks to protect assets in times of stress, while also having the flexibility to capitalise on opportunities as they arise. That is why we have adopted a more defensive stance in our portfolios, accumulating duration opportunistically and increasing liquidity throughout the year, looking to preserve capital as volatility increased. Looking ahead, we will seek to capitalise on improved valuations in higher yielding parts of global fixed income markets should volatility subside.

 

1The late 1970s is usually considered the starting point of the monetary policy regime most similar to current monetary policy practices.

2 While tightening by Volker’s Fed did affect the recession of 1980, the main cause was oil price shocks triggered by geopolitical events in Iran.