The wild ride for the global economy and markets this year is in no small part the consequence of the growing recognition of the scale of the US inflation challenge and the extreme measures the Federal Reserve will be forced to take to bring prices under control. When the Fed began raising rates in March, markets were pricing in a terminal rate of just 2,8 percent. As of mid-November, that expectation has risen to 5 percent—matching the forecast Bloomberg Economics set out in July.
Could they be forced to do even more? Absolutely. If the Fed is underestimating the natural rate of unemployment, or if the pandemic has resulted in a significant deterioration in productivity, a terminal rate of 6 percent could come into view.
There are also risks in the other direction, even if they’re less likely. It would take a lot more than the shocks to date, but a prolonged period of market mayhem — of the sort seen after the UK’s mini-budget fiscal fumble in September — might be enough to persuade the Fed to halt at a lower rate.
What higher U* would mean
At its September meeting, the Federal Open Market Committee’s dot plot showed a higher trajectory of rate hikes, despite a deterioration in the growth outlook. A simple explanation for this anomaly is that the committee’s estimate of u* — alternatively called NAIRU, or the unemployment rate associated with price stability — has risen from the traditional 4 percent.
The Bloomberg Economics rule — a modification of the classic Taylor rule that captures the relationship between unemployment, inflation, and Fed policy — can be used to work out an estimate of where the FOMC now puts u*. The u* values that best fit the September dot plot are 4,4 percent in 2022, 4,3 percent in 2023 and 2024, and 4,0 percent in 2025. That suggests the FOMC sees u* as temporarily elevated and expects it to gradually fall back to the pre-pandemic norm in 2025.
What if u* is even higher? A recent estimate by Fed staff put it in the 5 percent-to-6 percent range. Given the wrenching dislocations in labour markets that have resulted from the pandemic — with both companies and workers rethinking their priorities—that’s entirely plausible. Fed Chair Jerome Powell himself has said the natural rate of unemployment has “moved up materially.”
Holding the committee’s inflation forecast constant, a u* estimate of 5 percent would mean a terminal rate of 6 percent.
What lower productivity growth would bring
Broader macroeconomic factors, such as a slowdown in productivity growth, could also push up u*. If workers demand faster wage growth than what companies can earn from their output — either to compensate for higher inflation or simply because they have the bargaining power — the result is higher unemployment. That’s what happened in the 1970s, when productivity gains fell below wage growth.
Mainstream economists appear to believe the pandemic won’t result in a repeat performance. That assumption ignores some hard-learned lessons from the 1970s that linked high inflation to lower productivity:
High inflation means a sharp shift in relative prices. Businesses that have optimised their production processes on the assumption of stable input costs may find their old approaches obsolete or inefficient.
On their balance sheets, companies charge themselves for property, machinery, and other capital stock based on the equivalent rental price. High inflation raises the rental price, discouraging investment.
Uncertainty about inflation and central bank rates — as well as factors like geopolitics — adds an additional hurdle for companies making costly long-term investments. A project that looks profitable today might not be tomorrow if borrowing costs continue to rise.
All of those factors that weighed on productivity growth in the 1970s are also present today, suggesting a high risk that potential growth may be downshifting from its already low pace before the Covid-19 pandemic.
To gauge the impact of slower growth, we conducted the following experiment using FRB/US, the Fed’s workhorse model of the US economy: What happens if total factor productivity growth from 2022-25 is 0,5 percentage points lower than currently expected? That would correspond to a slowdown in gross domestic product from the current 1.8 percent to 1,3 percent by 2025.
Lower potential growth would mean a more overheated economy and higher inflation. Assuming the Fed recognises that and responds appropriately, FRB/US shows the federal funds rate would peak higher than the FOMC’s current baseline and stay higher for much longer.
Our exercise shows that the Fed’s anticipated terminal rate would increase to 5 percent in 2023 — considerably higher than the 4,6 percent suggested by September’s dot plot.
The effect of major market shocks
Bloomberg Economics’ view is that the market is overestimating the risk that a recession would stay the Fed’s hand. We think Powell has learned the lesson of the 1970s, when — aiming to support growth — the central bank prematurely paused its rate-hike cycle even though inflation remained uncomfortably high, with disastrous results. We expect the Fed to hold rates at our estimated 5 percent terminal rate through a US downturn in the second half of 2023.
Still, it’s not hard to identify significant risks on the horizon, from a collapse in US house prices and spillovers from the UK market turmoil, to the drag from a looming recession in Europe, to a hard landing in China.
The Fed has shown time and again it’s willing to pause rate increases if the data warrant. In the 2013 European debt crisis and the 2015 China market meltdown, for example, the Fed delayed tightening because of turmoil from abroad. That could happen again.
Using SHOK — our in-house model of the US economy — we simulate a scenario where the US is hit by a combination of weaker global demand and increased financial turbulence, resulting in a spike in the VIX, wider credit spreads, a stronger dollar, and reduced exports.
If that happens, that weaker demand will lower inflation and the Fed could get away with slightly less tightening than currently anticipated — with the fed funds rate at 4,1 percent in 2023 instead of 4,6 percent.
Officials at the central bank have recently shown a rare unanimity about the need to bring fed funds rates to the level indicated in the dot plot.
Yet there’s growing criticism by analysts and market participants that the Fed’s preferred path is excessive. An alternative perspective is that the FOMC’s projection for fed funds rates is by no means excessively hawkish, and that various labour market characteristics suggest still more upside. — Moneyweb