Fed Speak – Is the current monetary policy cycle different?

28 Feb 2024 , 09:25 AM

PUTTING THE CURRENT US MACRO MILIEU IN PERSPECTIVE

The legendary investor, Sir John Templeton, once said, “The 4 most dangerous words in the investment world are This Time It’s Different.” What is true of markets is true of economics too. Over the last few months, the Fed has been arguing that the current macro context is very different from the previous economic cycles and hence we need to look at the situation from an entirely new lens. It is in this context that the Fed Vice Chair Philip Jefferson evaluates how different is the current monetary cycle by looking at the granular aspects of the US economy. Speaking at the Peterson Institute of Economics, Jefferson does conclude that the current economic cycle is different; but hastens to add that all economic cycles are essentially different. But, more on that later. For now, let us look at Jefferson’s analysis of how the current economic situation in the US compares with previous occasions.

HOW DOES GDP GROWTH IN THE CURRENT CYCLE COMPARE?

According to Jefferson, the GDP growth in real terms in the current economic cycle has been surprisingly high, despite the vividly hawkish approach adopted by the Fed. To a large extent, this growth has been buoyed by consumer spending, which has remained robust even in the light of rising inflation. The liquidity infused into the US economy, post the pandemic, has created an undersupplied labour market, keeping wages relatively higher. Hence, despite the higher inflation, consumers appear to be having enough money to sustain the consumption engine. 

However, Jefferson hastens to add that since the last quarter of 2023, the household balance sheets have shown distinct signs of weakness. This is indicated by higher delinquency rates and a further decline in savings. This could have a lag effect, so the growth in spending could be relatively muted during 2024, but then the US economy has surprised in the past too. As Jefferson himself admits, there is still a lack of proper grasp of why consumer spending has been so resilient in recent years. One answer could be that it is a force of habit while the other explanation is that it is socially motivated consumption. Either ways, robust consumption has kept the GDP growth robust in this cycle.

LABOUR SITUATION IS EASIER, BUT STILL UNDERSUPPLIED

When the Fed set its monetary goals, it had two objectives in mind. The first was to curtail inflation back to the 2% mark and to ensure no instability in labour in the labour market. IN a sense, the Fed has managed to achieve, even while achieving a soft landing of the US economy in the process. Of course, the imbalance between labour demand and labour supply has narrowed, as labour demand has cooled while labour supply has improved. To look at some variables to buttress this point; there has been a decline in job openings by 3 Million from their peak in March 2022 and unemployment is now above its lows.

However, there is still an element of tightness in the labour market  with the job openings still at about 20% above their pre-pandemic level. This is largely because the sharp revival in demand post-pandemic resulted in labour being in short supply, pushing up wages. At the same time, layoffs have remained very low and payroll employment gains remains strong. In addition, the non-farm payroll monthly job gains have averaged over 2,89,000 in last 3 months. Though the unemployment rate at 3.7% has bounced slightly, it is still very close to its historical lows. What the current economic cycle has demonstrated is that it is possible to dis-inflate the economy without a spike in unemployment rate or mass lay-offs. That is a good signal; although that may not have been the intended outcome in the first place. 

HOW DIFFERENT IS THE INFLATION OUTLOOK IN THE CURRENT CYCLE?

Has the Fed made progress on inflation? Clearly, the 2% target may look elusive for now, but the fall from the peak is something to celebrate over the last 18 months. The fall in inflation does represent two things. On the one hand, it represents the unwinding of pandemic-related demand-supply distortions and also reflects the outcome of restrictive monetary policy of the Fed. The restrictive monetary policy has been instrumental in cooling the rampant demand side of the economy; so that supply has time to catch up. As per the 12 months estimates of the Fed, the personal consumption expenditures (PCE) inflation stood at 2.4%, for the year, just about 40 bps from the Fed target. Core inflation is sharply down.

There have been arguments that the January 2024 consumer inflation has been higher than the street expectations, but then a few swallows do not a summer make. However, the Fed has already cautioned that the last mile disinflation would be the hardest and hence one must not be taken in by the fact that just about 40 bps is left. This last mile promises to be very bumpy and volatile. However, on the inflation front, the Fed can take solace from the fact that the core inflation continues to be trending lower. Food and fuel tend to be cyclical, but the good news is on the structural inflation front. However, even under the ambit of core inflation, the prices of core goods have tapered while that of core services has not tapered to that extent. That remains a challenge for monetary policy. But, that may be the subject of another discussion, altogether.

WHAT CAN BE LEARNT FROM PAST ECONOMIC CYCLES?

Economic cycles of crests and troughs are nothing new in the US economy. There have been several events in the last 50 years like the Arab oil embargo of 1973, the Savings & Loans crisis of 1980s, the Gulf Crisis of 1990, the technology meltdown of 2000, and the global financial crisis (GFC) of 2007; which were all major economic disruptions that have happened long before COVID hit the world. Here are some key lessons from the past.

1. In 5 out of the last 6 such episodes of economic disruption in the US, the peak rate was reached once inflation was largely contained. In that sense, the current situation is more like 1989 wherein the rates peaked out, even when inflation was still elevated. To that extent, the current policy response is closer to the 1989 situation in the US.

    

2. The second point pertains to how the Fed justified its decision to cut rates. In all cases, the rate cuts have been to either pull the US economy from a crisis of slow growth or to prevent the US economy from dipping into slow growth. For instance, in the current context of the pandemic, the initial 75 basis points of easing were an outcome of downside risks to the US economy due to weaker global growth and high trade uncertainties. Only the subsequent easings in the cycle were triggered by the pandemic. The one exception was the rate cut cycle in mid-1995, where the trigger was not growth fears but the concern over inordinately low inflation. 

    

3. Thirdly, the lesson from the past is that monetary policy often gets complicated along with way, since the desired outcome is rarely what it should ideally be in the first place. For instance, in the case of the 1991 Gulf War, the 9/11 terrorist attack, the Global Financial Crisis, and in the 2020 pandemic; the policymakers had to take a different course of policy easing from the course they anticipated earlier in the cycle. The reason was that these events played a role in the contraction of economic activity, forcing the policy makes to ease aggressively. So, policy makers have had to improvise even in the past as vigilant and nimble response system has been the key to Fed action.

    

4. There was another takeaway in the policy response of the Fed in the aftermath of the global financial crisis, which began in September 2007. At that point, the macro data did not show too much weakness in the first couple of rate cuts. However, by December 2007, the incoming data began to display significant spillovers of the housing downturn to other parts of the economy, starting with financial companies showing larger than expected losses. The moral of the story from the past is that; not every economic easing results in improved growth. Quite often, the market outcomes can be counter-intuitive. This also highlights how quickly economic activity can weaken and without giving too many advance warnings.

    

5. One more learning from past cycles has been that not all actions have the intended consequences. For instance, the year 1967, the monetary policy was eased in response to slowing economic growth, but it resulted in a spurt in inflation. Similarly, in the current cycle, the cut in rates since early 2022 were largely neutralized by the Russian invasion of Ukraine in early March 2022, which resulted in a surge in oil price inflation.

    

6. At this juncture, there is a debate on the time table for rate cuts by the US Federal Reserve. Currently, the Fed has committed to 3 rate cuts in 2024 and 4 rate cuts in 2025. However, it is yet to spell out a time table for the rate cuts. The lesson from 1995 is that careful and calibrated easing may be the best choice at times. This allows the Federal Open Markets Committee (FOMC) to assess inflation and data flow to ensure that inflation stays in check. 

According to Jefferson, the current cycle could bear a close resemblance to the 1995 episode when the easing started much before inflation had touched its target level, but the easing was done in a gradual manner. That could be the template for the current situation.

WILL THIS ECONOMIC CYCLE BE REALLY DIFFERENT FOR THE FED?

That brings us back to the core question; is this economic cycle really different, and if so, how is it different. To quote Jefferson, all economic cycles and all monetary cycles are intrinsically different, and to that extent, this statement is correct. However, some lessons from the past may help the fed to decide when to start rolling back the rate hikes. According to Jefferson, he still sees 3 distinct risks to the current economic cycle at this juncture.

• The first and the biggest risk is that the consumer spending could be even more resilient than currently expected. There has been enough evidence of that in the last couple of years where consumption has stayed robust despite sharply higher interest rates. This could result in the progress towards the 2% inflation target to slow. As long there is enough liquidity sloshing around in the system, inflation control will fall short.

   

• The second risk is that employment could weaken as the factors supporting economic growth fade. In short, the low unemployment comfort of today could change drastically if the consumption falls rapidly, in which case we could see a rapid spike in unemployment. That could just about complicate policy decisions for the Fed.

   

• Last, but not the least, geopolitical risks have been elevated for quite some time. Russian war in Ukraine is far from over. China continues to indulge in sabre rattling in the South China Sea. Above all, the consistent attacks on ships in the Red Sea by Houthi Rebels and the ongoing war between Israel and the Hamas is also having its own repercussion on global geopolitics. These are tough situations to really extrapolate.

In the words of Jefferson, the current cycle remains unique in that it has shown tremendous resilience in terms of jobs and consumption. That has ensured that economic growth sustains, but going ahead, it could also mean that inflation may be tougher to rein in. For now, the only thing that the Fed can do is to continuously evaluate its policy options based on incoming data.