The Fed is no surgeon

 

Orchestrating a soft landing

The July rally, which stretched into the first few weeks of August, was based on a triple narrative: inflation is falling and a Federal Reserve (Fed) pivot is around the corner; rate hikes should result in a soft landing; inflation is a positive factor for corporate earnings. Each of these three pillars is about to face a tough test during the last four months of 2022 or, if not now, almost certainly in 2023.

One of the most important of these pillars is the ability of central banks to orchestrate a soft landing. In this latest edition of Simply put, we consider whether the Fed has the surgical accuracy investors seem to perceive it does? Despite its good intentions, the growth cost of the Fed’s belated crusade against inflation will only be disclosed after a significant delay.

 

Tools to estimate impact

In macroeconomic analysis, economists often rely on a valuable tool: impulse response functions. Behind this esoteric name lies a statistical tool used to estimate the impact of one economic variable versus another over time. Armed with this analytical framework, generations of economists have been able to analyse the impact of central bank rate hikes on inflation, for example, by taking the potential lag between the action (the rate hike) and the consequence (lower inflation) into account.

This tool can be used to answer the following question: what is the cost in terms of real growth of a 100 bps rate hike? A complex question that requires an adapted tool to answer it – a role undertaken by macroeconomic models. Figure 1 presents the model's answer, based on US data from 1973 to 2022. The chart highlights the impact evolution of a 100 bps rate hike over a 3 year period – the time such an economic policy needs to take effect. The key findings are as follows:

• A 100 bps increase has an average real growth cost of around 2%
• This economic impact only statistically starts to affect the economy more than a year after the rate hike has taken place
• The uncertainty surrounding the economic impact of a rate hike encompasses multiple scenarios, from a much smaller impact than the average 2% (typically defined as a soft landing) to a much larger one (as happened in 2008)

 

Figure 1: Simulated impact of a 100 bps rate increase on US real growth, 1973-2022

Source: Bloomberg, LOIM

 

A lag between action and impact

Unlike surgeons, the Fed has to wait several quarters to judge the impact of its policy changes on inflation and growth, quarters during which it must continue to make monetary policy decisions. We should therefore acknowledge the difficulty of the task of central bankers face and the risk that hangs over the decisions taken by the Fed and the European Central Bank (ECB) in particular.

Since the beginning of the year, the Fed has already raised rates by a little over 200 bps and the market expects a further 150 bps in the coming quarters. Figure 2 shows the evolution of Fed policy, using the 2017-2018 rate hikes as a benchmark. For the moment, we remain on the side of those expecting a moderate impact:  

• The Fed is committed to a restrictive policy stance, but the path to restrictive territory may slow in the months to come as inflation finally rolls over
• Despite 350 bps of policy rate hikes expected this year, long-term real rates have repriced 150 bps from -1% to +0.5% – a cost of capital we do not judge to be high enough to inflict the worst outcomes on the real economy; especially since…
• … there are no major imbalances from other agents – such as household debt in 2008 or the technology bubble in 2001
• Consumers are still sitting on a large cushion of savings from the residual Covid fiscal stimulus
• Finally, inflation should cease to create positive surprises, gradually declining to remain more modestly above the bank's inflation target for a few more quarters

 

Figure 2 : The Fed's monetary scenario

Source: Bloomberg, Lombard Odier

 

The risk to this scenario is outlined in the lower part of figure 1: there is a non-zero probability that the Fed and other central banks will be dogmatic in their fight against inflation given it has spread to multiple sectors of economic activity. Excessive tightening would have a detrimental impact on growth which could create an accelerated impact – a “hard landing” scenario.

This remains a risk at this stage, but keep in mind that the job of a central banker is not precision, far from it. If 2022 and 2023 carry the seeds of risk, then that is the risk of excessive tightening. While the market dismissed this scenario in July, it has recently become less confident and the return to pragmatism suggests that caution is warranted at this stage of the cycle.

Simply put, the damage to economic activity caused by the Fed's rate hikes will probably not be visible until early next year. The recession should be mild but could be more severe if the Fed acts more forcefully in the face of persistent inflation.

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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.

In terms of macro data, this week has extended last week’s long stream of bad news. In the US, the housing data continues to be a source of concern: new homes sales declined by 12% in year-over-year terms, having “only” declined by 8% last month (yoy). Pending home sales showed a similar decline, losing 22% to last year’s value in July versus 19% a month ago. Having said that, jobless claims remained solid: the US jobs market is probably the only dimension of the US economy which is not showing signs of deceleration. Jobless claims reached 243k last week versus 250k the week before. We have passed an inflection point in this time series, but the scale of job destruction seems quite small at the moment. Finally, leading surveys are pointing to a mild deceleration, be it the Chicago Fed National indicator (+0.27 from -0.19) or the Kansas Fed survey. This mix of data still shows that the US economy is slowing down, but data disagreements are not helping the average investor determine the potential for a recession or not. Our US growth nowcaster balances all of these elements together and crossed the recession threshold on 18 August.

In Europe, the news flow has been light. The S&P PMIs are painting a picture of the Eurozone economy slowing down, but not as fast as expected. For example, the Eurozone Manufacturing PMI was expected to have declined from 49.8 to 49.0 but was finally published at 49.7. Bad, but not that bad. The same happened with the German IFO survey: a sharper contraction was expected, but the published number was lower than the month before although higher than the consensus.

There were no major economic releases in China this week and our macro indicators continue to show that the Chinese cycle remains in a difficult situation: this will not help the rest of the world economy, which is decelerating overall.

Our nowcasting indicators currently point to:

• Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum. The US economy breached its recession threshold on 18 August
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US. Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish 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). For illustrative purposes only