The current war on inflation is dominating headlines. Societies are high on duration, rates are rising, and it is hard to imagine an environment in which asset owners could suffer more. Higher rates are needed, as it remains the only cure we have for inflation, but now that US inflation seems to have peaked an obvious question comes to mind – how much further do rates need to go? There are various ways to assess this point; here we dive into these complex waters to review two of them – one we do not like and one that we do.

 

So long, Taylor rule

The first approach is to adopt a normative point of view: what is the recommended level for central bank rates when core inflation exceeds 6%? The easiest and most common way to answer that question is to use a “Taylor rule” – rules originated by John Taylor that map inflation and growth into “normal” levels of target rates. A more evolved version is the Mankiw rule which adds unemployment into the mix of ingredients. A model for the current period is shown in Figure 1. The grey line shows an estimate of what the Federal Reserve's (Fed) rate should look like with the current level of inflation, growth and unemployment. At 13%, it is hard to trust such a high number given it seems at odds with other data. Many empirical economists offer a way out of such inconsistent data by using a smoothed version. Central banks have a tendency to smooth their reaction function to inflation in order not to unsettle financial markets and economic agents. The black line on Figure 1 shows a smoothed parameter which is in line with other estimated values and yields - a far more realistic estimate of 5.75% as a recommended rate. Yet the actual rate is still far from that number, even when it comes to expectations. The rule indicates that the Fed is behind the curve and should have reacted more aggressively to inflation. This conclusion is shared by many macro-observers on the back of a (false) belief that rates should be proportionate to inflation’s level. In our view, to curb growth and inflation, rate hikes must simply make leverage seem unattractive by making sure that investment projects are no longer profitable due to the higher funding costs. The comparison point sits between real growth (as a proxy to the real return on investment) and real rates (which react to hikes on an almost 1 to 1 basis). During Taylor’s study period, growth was structurally high, while today it is much lower meaning it will require fewer rate hikes in 2022 to forcefully slow down the economy.

 

Figure 1: Comparison of Taylor / Mankiw Rules versus the Fed Fund Target Rate

Source: Bloomberg, LOIM

 

How significant should the rates shock be?

In order to gain a better understanding of the relationship between rates, growth and inflation, another type of method could be used. Economists often use “impulse response functions”, which are models that allow the study of how shocks are propagated within an economy. Using data from 1971 to 2022, this method put us in a position to answer the following questions:

• What is the decline in real growth needed to cut 1% from excessive inflation?
• How many rate hikes are needed to deliver that precise level of growth contraction?

With this information, we will then be in a position to answer the ultimate question: have rates in the US already reached a high enough level (and, as a consequence, in the Eurozone)? Our calculations, excluding the 2020-2022 period, show that:

• A 1% decline in real GDP growth leads to a 1.23% decline in inflation on average over a 2-year period.
• A 1% increase in target rates results in an average decline in real GDP growth of -0.84%, also over a 2-year period.

These estimates lead to the following conclusions:

• In 1979, when core inflation exceeded the Fed’s target by 12%, around a 10% decline in GDP growth was needed, which could have been achieved with an 11% increase in central bank rates. Figure 2 shows that this is more or less what happened.
• In 2022, inflation is exceeding the central bank’s target by 5%, requiring a 4% decline in GDP growth, which can be obtained with a 4.5% rise in the target rate. Again, these estimates are shown in Figure 2.

From these calculations, it seems pretty obvious that the current market pricing of target rates – as per the Fed Fund Futures – shows that the necessary level of rates has already been reached: the Fed has done what is necessary.

 

Figure 2: Expected and realised scenarios in 1979 and 2022 to obtain a necessary moderation in core inflation

 

 

Source: Bloomberg, LOIM

 

Soft landing or no soft landing?

So, if the Fed’s job is done, does it mean that a recession is imminent? A near 4% contraction seems large, particularly given this is close to the scale of the economic shock observed during the Global Financial Crisis. In this situation, the starting point matters a lot: how healthy was the position of US consumers prior to the hikes, as this is likely to help them weather this storm if large enough. Figure 3 shows the current “wealth to GDP” ratio for US consumers. The level of wealth that resulted from President Biden’s fiscal plans is apparent in the chart, as well as the extent to which rate hikes have already started eating into this. The recent decline in these wealth numbers suggests a large part of the economic contraction has already been triggered by higher rates. From that perspective, wealth levels are now back to their longer-term levels and hints that a large part of the wealth destruction has already happened – without yet impacting GDP numbers. If the slowdown stops here, a soft landing remains likely. However, if higher rates continue to weigh on the US economy, the soft landing could very well become a hard landing and our nowcasting charts are already showing the tremors of such a situation. No wonder the level of macro uncertainty has increased since the last inflation report and the rally it triggered. This is a story we will continue to follow closely.

 

Figure 3: US Wealth to GDP Ratio

Source: Bloomberg, LOIM

Simply put, the war on inflation is harming economic growth. With rates at current levels, we are at the threshold between a soft landing and hard landing – which is elevating macro uncertainty.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Our nowcasting indicators currently point to:

• Worldwide growth is declining and the risk of recession is rising. The US signal has extended its previous decline to reach 40%, which is 5% below the recession threshold.
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere. The recent US inflation report shows a fourth decline in year-over-year inflation, consistent with the trend shown by our indicator.
• Central banks should remain hawkish. The European Central Bank (ECB) is notably likely to be more aggressive than expected.

 

World growth nowcaster: long-term (left) and recent evolution (right)

 

World inflation nowcaster: long-term (left) and recent evolution (right)

 

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).