Why I Remain Positive on Growth

Summary

• Federal Reserve (Fed) tightening cycles are necessary but not sufficient for recessions.
• The current tightening cycle, one of the strongest on record, is unlikely to cause recession or disinflation because of poor policy transmission and because the US economy is stuck in a high inflation regime.
• Risks to my view come mainly from lower immigration, bad commercial real estate loans, and weaknesses in smaller regional banks but are unlikely to materialize in 2024.

Market Implications

• I still expect no 2024 cuts and a median dot showing only one 2024 cut in the June Summary of Economic Projections (SEP). This compares with the market expecting 1.2 cuts by end-2024.

Fed Tightening Necessary but Not Sufficient for Recessions

In this note, I explain my positive view on growth, which basically reflects the lack of transmission of Fed tightening.

The economy is much more often in expansion than recession (Chart 1). Since January 1965, the economy has been in recession about 10% of the time. Removing the high instability period of the 1970s (i.e., start counting from 1985), the economy has been in recession only about 5% of the time.

This reflects that, in a market economy, businesses must run operating surpluses to keep going. This makes for positive growth at an aggregate level.

Therefore, I think understanding what happens next is more about finding a reason why growth should stop rather than one explaining why it should continue.

Chart 1 also shows that Fed tightening has preceded all recessions, but not all Fed tightening has led to recessions.

This Fed Has Been Tightening Hard

Since 1965, there have been three tightening cycles that did not cause recession (Table 1). The 1965-66 tightening cycle did not lead to a recession but did not stabilize inflation either, largely because Fed tightening was too timid.

The 1983-84 and 1993-95 tightening cycles did not cause recession yet stabilized inflation. I think this was largely because the US economy was approaching or already in a low inflation regime and because Fed credibility was strong. When economic agents believe the central bank will trigger a recession to reduce inflation, they adjust their price behaviours accordingly. Thus, the Fed does not need to engineer a recession to break down inflation expectations.

In 1983-84, memories of the deep recessions of 1980-82 were fresh and economic agents were quick to adjust their expectations of inflation when the Fed started hiking. The painful recessions of the early 1980s established Fed credibility for the following decades. In 1993-95, inflation was already close to the Fed’s target and slowing when the hiking cycle started.

I think this time the limited impact of Fed tightening on growth does not reflect that the Fed has been too timid. The Fed has hiked the Federal Funds Rate (FFR) 525bp, the average since 1965. Furthermore, because the Taylor rule FFR has been falling since Q1 2022, the actual FFR is now above the Taylor rule value for the first time since the 1980s (Chart 2). That is, based on the Taylor rule, the Fed has implemented one of its strongest tightening cycles since the 1960s.

A decline in the Taylor rule during the tightening cycle is unprecedented and reflects the unprecedented supply-driven nature of the recent disinflation. Unemployment and inflation have been falling in sync largely due to the unwinding of the pandemic – mainly supply-side – imbalances.

Rather, the lack of recession despite unprecedented tightening reflects poor policy transmission.

Fed Tightening Not Transmitting to the Real Economy

In the minutes of the 1 May FOMC, the Fed expressed concerns about poor policy transmission. Poor transmission reflects changes in the economy that have reduced its interest rate sensitivity. These include:

1. An immigration surge (i.e., an increase in the supply potential of the economy), which is beyond the reach of the Fed.
2. Post-GFC deleveraging and long-term fixed rate debt of households (Chart 3).
3. Financialization of the real economy:

• Households net worth remains higher than before the pandemic, which could explain a historically low savings rate (Chart 4).
• A recovery in residential real estate prices is driving a recovery in residential investment, despite the highest mortgage rates in 20 years (Chart 5).
• Net corporate interest payments have fallen since the Fed started hiking, which aligns with corporate net debt turning negative since 2020, due to decades of financial assets growing faster than debt (Chart 6).

But the strongest evidence of Fed tightening poorly transmitting to the economy could be the equity rally despite the reduction in expected Fed cuts in 2024 (Chart 7).

Neither Recession Nor Stabilization

While Fed tightening so far is unlikely cause recession, unlike the 1983-84 and 1993-95 tightening cycles, this time tightening is unlikely to stabilise inflation. I think this is because the pandemic has moved the US economy to a high inflation regime where expectations are stuck above the Fed’s target. By contrast, inflation in these earlier cycles was approaching or in a low inflation regime.

Also, with inflation above the Fed’s target for over three years, Fed credibility is likely to be weaker than in the mid-1980s and 1990s.

Finally, because of the positive core-energy inflation correlation characteristic of high inflation regimes, last year’s decline in energy prices helped reduce core inflation. However, such a decline is unlikely to repeat this year.

How I Could Be Wrong

The biggest risks to my positive growth view include:

A large decline in immigration. This seems unlikely as it would require legislative changes that seem unfeasible ahead of the November elections.

Large losses on Commercial Real Estate (CRE) lending that would cripple banks’ ability to lend. This is unlikely because banks and regulators have been expecting these losses. Also, the loss of wealth from bad CRE loans is likely to fall on bank shareholders (i.e., a minority of households) and be spread over a long period.

Continued weaknesses in smaller banks causing a systemic crisis. This is likely to remain hidden thanks to the Fed’s operating framework, based on ‘abundant’ reserves. Any open bank failure will likely be resolved through liquidity provision and a government backstop for all depositors, per current practice.

Market Consequences

I still expect no 2024 cuts and of a median dot showing only one 2024 cut in the June SEP. This compares with the market expecting 1.2 cuts by end-2024.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)