Monetary Policy

Special Report

Highlights The possibility that the Fed could cut interest rates later this year if inflation falls more than they expect has caused a renewed focus by market participants on the Fed’s neutral rate views. Owing to its low neutral rate estimate, we can envision a scenario in which inflation decelerates enough to make the Fed feel comfortable easing monetary policy from current levels to a point that it believes is still tight. It is very likely true that the US neutral rate of interest fell for a time following the global financial crisis, but this decline was not likely permanent. A lower neutral rate was caused by US household deleveraging, which ended in the middle of the last economic expansion. The normalization of the neutral rate during the last expansion was not evident to the Fed and many investors, because it was masked by a truly exogenous shock to inflation expectations during the 2014-2016 period. As a result, the Fed never revised its low neutral rate view prior to the pandemic, and currently views the existing stance of monetary policy as extremely restrictive. Any meaningful indications that the Fed is likely to cut the fed funds rate before a recession has begun would have a significant impact on our recommended cyclical investment strategy. We would very likely recommend raising exposure to risky assets in this scenario. For now, this remains a possible but not probable outcome. Over the longer run, however, we think this scenario would risk quite a negative outcome for both equity and fixed-income investors. If the Fed inadvertently moves monetary policy back into stimulative territory over the coming months, it would significantly increase the chances of elevated structural inflation. That would likely be devastating for both equity and bond prices, as sharply higher rates cause a severe contraction in economic activity. Feature Over the past month, there has been a renewed focus by market participants on the Fed’s low neutral rate views. Federal Reserve Chair Jerome Powell seemingly opened the door to the possibility that the Fed would cut interest rates if inflation falls further than they expect over the coming year, potentially even if the unemployment rate has not increased meaningfully. The idea that the Fed could move short-term interest rates lower, even if growth is stable and reaccelerating, emerges primarily from their view of a very low neutral rate of interest. While the neutral rate is a technical or arcane concept for many investors, it is extremely important because it determines whether any given interest rate level is stimulative or restrictive. It has been the long-stated view of several BCA Research services that the US neutral rate is meaningfully higher than the Fed and many investors believe. Table II-1 presents a (non-exhaustive) list of BCA Research reports dating back to at least 2019, when we presented this perspective. Table II-1BCA Has Long Argued That The Neutral Rate Is Higher Than The Fed And Investors Believe In this report, we consider renewed investor interest in the question of the neutral rate as a welcome opportunity to revisit what has been a core BCA view for some time. We review the theoretical determinants of the neutral rate of interest, and compare the empirical record to what theory would predict. We also discuss why the “new neutral” narrative emerged during the last economic cycle, and why we believe that a decline in neutral rate – that did likely occur in the years following the global financial crisis – was temporary. We conclude by underscoring that the Fed’s low neutral rate view could create the basis for pro-risk positioning over the coming year, but that this scenario is not yet likely and would also create meaningful longer-term risks for investors. As such, we continue to recommend that investors position conservatively over the coming 6-12 months. The Theoretical Determinants Of The Neutral Rate Of Interest The idea of the neutral rate of interest, originally termed the “natural” rate of interest, originated from Knut Wicksell in 1898. Wicksell argued that “there is a certain rate of interest which is [natural/neutral] in respect to [prices], and tends neither to raise nor to lower them.” Since then, the concept of the neutral rate of interest has been expanded to represent the interest rate level that is consistent with the overall economy being in a state of equilibrium, all else being equal. Generally speaking, that means output that is in line with its potential, a balanced labor market, and inflation that is in line with the central bank’s target. While the neutral rate is a technical or arcane concept for many investors and is not directly observable, it certainly exists and is extremely important from an investment strategy perspective. It is clear from several decades of experience that interest rates have a powerful effect on aggregate demand, underscoring that there must be some level at which interest rates cease to stimulate economic activity and begin to restrict it. And from an investment strategy standpoint, the entire basis of monetary policy stabilization efforts hinge on whether monetary policy is stimulative or restrictive at any given interest rate level, underscoring that investors need to have a sense of where that boundary is in order to forecast economic activity and, by extension, corporate profits. From a theoretical, closed-economy perspective, the main determinants of the neutral rate of interest can be derived from the classic Solow Growth Model (see Appendix 1):1 Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand, and faster growth in aggregate income will raise the sustainable level of interest on borrowed funds for both investment and consumption. This will elevate the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will raise the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require considerable physical capital will tend to have a higher neutral rate of interest. By the same token, economies in which the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest. Neutral Rate Theory Versus The Empirical Record The historical evidence shows a somewhat different picture than what theory would suggest, at least in terms of justifying the Fed’s very low neutral rate view. Chart II-1Trend GDP Growth Closely Correlates With Bond Yields Let’s first address trend GDP growth as a determinant of the neutral rate of interest. We entirely agree with this framework, and believe that trend growth is by far the dominant driver of the neutral rate. Chart II-1 highlights that 10-year government bond yields have been closely linked to trend rates of growth over the past six decades. Deviations in this relationship have occurred in the past, but, until the 2008-2009 global financial crisis, they were explained by the lagged difference in inflation from 2%. That means that prior to 2008, the fact that interest rates were above or below trend growth mostly reflected Fed decision-making, rather than structural factors. On the second question of higher/lower national savings and its impact on the neutral rate of interest, we agree that cyclical changes in the savings/investment balance likely have an impact on interest rates, because they will be strongly linked to fluctuations in economic activity and the output/jobs gap. But as we discussed in our April 2022 Special Report,2 we don’t really see much evidence of a lasting structural savings/investment effect on the neutral rate beyond a brief period in the 2000s. Chart II-2 makes this point using a globally comparable savings measure: gross national savings, calculated as gross national income less total consumption, plus net transfers. In the US, the chart shows that gross savings have been trending down over time, even prior to the global financial crisis, underscoring that the neutral rate of interest should have moved up according to the Solow growth model (holding all else constant). Globally, it is true that gross savings rose significantly from the early-2000s until the global financial crisis, a phenomenon that has been referred to as the “global savings glut” – which occurred mainly because of China’s massive current account surplus. We do find evidence that the global savings glut reduced long-maturity US Treasury yields during this period, but it was a temporary effect that, on its own, caused only a modest gap between interest rates and trend growth. Chart II-3 shows that all three of our estimates for the 10-year Treasury term premium fell during this period, which did prevent long-maturity yields from rising as the Fed raised interest rates and probably did contribute to a relatively early inversion of the US yield curve in 2006. Chart II-2US Gross National Savings Have Trended Lower Over Time Chart II-3The Global Savings Glut Did Lower Bond Yields Somewhat In The 2000s... But Chart II-4 highlights that Fed policy also greatly contributed to low bond yields during this period, given that the Fed cut the funds rate aggressively during the 2001 recession and kept it there for close to three years. On the one hand, typical monetary policy rules supported the idea that the Fed should have been slower to raise interest rates. On the other hand, even the more dovish versions of the Taylor rule show that the Fed cut too deeply, which significantly depressed 5-year Treasury yields and helped inflate the housing bubble that ultimately caused the subprime and global financial crises. On the third question of capital intensity, based on several measures of intensity, there is little basis to believe the neutral rate has permanently declined in the US. Chart II-5 shows that there has been no structural downtrend in total US investment (private plus government) as a share of GDP and that this measure today is not far from its post-war median. Chart II-6 makes the same point from the perspective of the incremental-capital-to-output ratio (ICOR), which accounts for depreciation, and shows that there has been no structural uptrend in the ICOR regardless of what measure of the real capital stock is used. Chart II-4...But So Did Too-Easy Fed Policy! Chart II-5No Structural Downtrend In US Investment As A Share Of GDP Chart II-7 shows that capital-intensive investment (equipment and structures) has fallen as a share of total investment. It is conceivable that this is leading to a lower neutral rate of interest. But this has corresponded with an increase in the depreciation rate, which theoretically supports a higher neutral rate. More importantly, this decline in capital-intensive investment has been occurring for decades, and interest rates did not fall meaningfully below the prevailing or potential rate of economic growth until the mid-2000s, and not persistently so until after 2008. Chart II-6No Uptrend In The US ICOR Chart II-7Capital-Intensive Investment Has Fallen As A Share Of Total, But This Is Not A New Trend Some Additional Points On The Empirical Record Two other points are worth noting with respect to evidence in favor of or against a permanently lower neutral rate of interest. The first relates to the 2018-2019 period, one that many investors have pointed toward as evidence that the neutral rate is indeed meaningfully lower then trend rates of economic growth. The crux of this argument is that interest rates crossed into tight territory according to common academic estimates of the neutral rate of interest (Chart II-8), and that the US economy slowed meaningfully in response. The US yield curve inverted, and the Fed was forced to cut interest rates by 75 basis points in order to stabilize growth, which is exactly what one would expect to see if interest rates had ceased to become stimulative. As a first point, we have highlighted in previous research that econometric estimates of the real neutral rate of interest, such as those calculated by the (now discontinued) Laubach-Williams (L&W) model, are almost certainly wrong.3 Many econometric approaches to determining the neutral rate of interest rely on the simultaneous specification of other variables such as the output gap. These values can be used to determine whether the model as a whole is producing sensible results. As of the last available update to the L&W model, the US output gap turned positive in Q1 2012 (Chart II-9), while the US unemployment rate was 8.3%. That is a plainly wrong result, and underscores that the L&W model is unreliable, because the output gap is a central element of the model’s estimate of the neutral rate. Other neutral rate estimates, such as those derived from the New York Fed DSGE Model, offer confidence ranges so wide that they render the estimates themselves useless. At an 80% confidence range, the New York Fed’s model suggests that the real neutral rate was between -9.4% and 30.5% as of December 2020. Today, the model suggests that the real neutral rate is somewhere between 1.2%-4%. That is not particularly helpful for investors. Chart II-8Was The 2018-2019 Episode Evidence Of A Low Neutral Rate? The Answer Is No. Chart II-9Was The Output Gap Closed In 2012 At An 8.3% Unemployment Rate? It Was Not.   In addition, as we noted in our April 2022 Special Report, the idea that the 2018-2019 episode supports a very low neutral rate view entirely ignores the fact that the US and global economies were negatively impacted by a politically-driven nonmonetary shock to aggregate demand during this period: the China-US trade war, which also impacted or targeted several major advanced economies. Chart II-10 highlights that global trade uncertainty exploded during this period, which severely damaged business confidence around the world and caused a slowdown in global industrial production. Tighter Chinese policy also likely contributed to the slowdown in global activity, but the bottom line is that factors other than US monetary policy contributed to economic weakness during this period. It is therefore incorrect to infer from the 2018-2019 experience that interest rates rose to or exceeded the neutral rate of interest. The other empirical point worth noting is the important information conveyed by the National Federation of Independent Business (NFIB) survey about the stance of monetary policy. While the NFIB includes firms that are not particularly capital intensive in its surveys – the typical member employs ten people and reports gross sales of about $500,000 a year – the details of the survey can help investors triangulate whether monetary policy is easy or restrictive. Chart II-11 illustrates the short-term interest rate paid by small businesses, alongside the percent of NFIB survey respondents reporting demand and interest rates & finance as the single most important problem facing their businesses. The share of businesses quoting interest rates & finance as their most pressing problem has historically been small given that sales and compensation costs are usually the dominant drivers of firm profitability, but the series shown in Chart II-11 allow point-to-point comparisons vis-à-vis interest rates and contextualizes those answers through the lens of rising or falling demand. Chart II-10The US Economy Slowed In 2018-2019 Because Of A Massive Trade Shock, Not Because Of interest Rates Chart II-11The NFIB Survey Shows That Interest Rates In 2018-2019 Were Not Restrictive   What is particularly important about Chart II-11 is where the series in panel 2 was toward the end of 2018 / early 2019, just before the Fed began to cut rates in response to the Trump trade war. While the number of firms reporting rates/finance as their most important problem was rising at that time, it was no different than it was in 2005/2006 when the small business loan interest rate was at roughly the same level. This is in sharp contrast to the much higher number of firms reporting rates/finance as their top problem in the face of lower interest rates in the early aftermath of the global financial crisis. This suggests that the neutral rate of interest did fall in the early years of the last economic recovery, but also that it had normalized by the time that the COVID-19 pandemic began. The conclusion for investors is that, while it is very likely true that the US neutral rate of interest fell for a time following the global financial crisis, this decline was not likely permanent – in striking contrast to the Fed’s views about the neutral rate and the “new neutral” market narrative. In the latter half of the last economic cycle, the neutral rate of interest was either equal or very close to trend rates of economic growth. The New Neutral Rate Narrative The idea that the neutral rate of interest has fallen well below the trend rate of economic growth did not emerge spontaneously. It occurred in response to the fact that growth and inflation during the last economic cycle was very weak relative to historical norms, despite the fact that the Fed kept short-term interest rates pinned to the zero lower bound for seven years. We agree with the perspective that, first, the neutral rate of interest fell for some time following the global financial crisis, and that, second, it occurred because of a savings/investment imbalance. But this imbalance was cyclical in nature rather than structural, in the sense that it was caused by the events leading up to and following the subprime and global financial crises – not exogenous shifts in savings preferences. And it proved to be a temporary decline, not a permanent shift, as some investors and the Fed came to believe. Chart II-12 highlights the clear source of excess savings for several years following the global financial crisis. The housing and debt-focused nature of the 2008-2009 Great Recession caused a multi-year period of US household deleveraging, which actually saw the outstanding level of household mortgage debt fall (something that had never occurred in the post-war era). Combined with a significant tightening in credit availability because of the balance sheet conditions of US banks and newly-instituted regulations, total household credit growth fell well below the growth rate of disposable income despite rock-bottom interest rates (panel 2). This period of deleveraging almost exactly matches the period over which the US economy had a negative output/jobs gap, underscoring that this excess savings period was cyclical rather than structural in nature and occurred because of the balance sheet effects of the great recession. Chart II-12The Neutral Rate Fell Because Of US Household Deleveraging, Which Is Over Chart II-13Growth Was Historically Weak Last Cycle, But Only Because Of The First Few Years Of The Expansion     As Chart II-12 highlights, this active deleveraging process ended around 2015, roughly in the middle of the expansion. Chart II-13 highlights that the very weak growth of the last expansion occurred entirely while US consumer deleveraging was underway. The chart shows that real per capita growth in the latter half of the last economic expansion was not meaningfully different compared to previous economic recoveries, despite the fact that this is when interest rates were normalizing and when several major nonmonetary shocks to US and global growth occurred, such as the oil-driven CAPEX recession of 2014-2016 and the Trump administration’s trade war with China and several DM countries in between 2018 and 2019. From Weak Growth To Weak Inflation Chart II-14US Inflation Remained Below Target Even After US Household Deleveraging Ended The events between 2014 and 2016 were also a very important determinant of why the Fed and many investors believed that the neutral rate permanently declined – even though economic growth meaningfully improved in the latter half of the last economic cycle. We noted above that the concept of the neutral rate of interest has been generalized to represent the interest rate level that is consistent with the overall economy being in a state of equilibrium, including for inflation (with equilibrium defined as the central bank’s target). The fact that core PCE inflation remained below the Fed’s 2% target for essentially the entire period of the last expansion acted as strong evidence for many, including the Fed, that interest rates were likely to remain permanently low (Chart II-14). As we discussed in detail in our January 2021 Special Report,4 inflation is only consistent with a central bank’s target if 1) inflation expectations are in line with that target and 2) there are no cyclical effects pushing inflation higher or lower. These cyclical effects are typically driven by the output/jobs gap, but supply shocks, even for core inflation, can push inflation away from its equilibrium level for some time. Chart II-15Massive And Unexpected US Shale Production Caused A Huge Shock To Oil Prices Inflation expectations remained stable for four-to-five years following the global financial crisis, which is surprising given the size of the jobs gap during this period. We believe that expectations stayed very well anchored during this period because of the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. While inflation expectations did not decline during this weak growth period, the long-lasting weakness in demand from household deleveraging left expectations vulnerable to exogenous shocks. In 2014, such a shock emerged: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-15), which even surprised energy sector experts and resulted in a substantial and long-lasting imbalance in the global oil market. We view this event as a genuinely exogenous shock to prices, given that research and development of shale technology had been ongoing since the late 1970s and only happened finally to gain traction around 2010. Chart II-16 shows that the 2014 oil price collapse caused a clear break lower in our adaptive inflation expectation measure, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-17). Chart II-16A Collapse In Oil Prices Collapsed Our (Already Vulnerable) Measure Of Inflation Expectations... Chart II-17...As Well As Long-Term Market And Household Inflation Expectations This disinflationary shock to inflation expectations explains why actual core inflation was below the Fed’s target in the latter half of the last economic expansion when growth was on par with that of previous expansions and the output/jobs gap was nearly closed. Strangely, the Fed and many investors did not seem to recognize this effect, and instead saw the ongoing weak inflation during this period as supporting the idea of a permanently low neutral rate. The key point for investors is that while the neutral rate did decline during the last economic cycle, it was a temporary phenomenon for which normalization was masked by an exogenous shock to inflation expectations. As a result, the Fed never revised its low neutral rate view prior to the pandemic, and currently views the existing stance of monetary policy as extremely restrictive in order to bring inflation rapidly back to its 2% target. The Neutral Rate Today, The Fed, And The Current Economic Outlook Chart II-18No Savings/Investment Basis To Believe Neutral Is Different Than Trend Growth Based on our analysis presented above, we do not currently believe that the US nominal neutral rate of interest is meaningfully above or below the current trend rate of economic growth. Based on the CBO’s estimate of real potential GDP growth (1.8%) plus the Fed’s inflation target of 2%, that implies that the current nominal neutral rate is just under 4%. However, we note that CBO’s nominal potential GDP growth projections, as well as actual GDP growth over the past decade, would imply an even higher nominal rate. We discussed above that a savings/investment imbalance can exert cyclical effects on interest rates. Many BCA Research services have noted the existence of excess household savings that have accrued during the pandemic. Some investors have been puzzled by how to balance this observation against the fact that interest rates have risen at their fastest pace in four decades, to a level above our estimate of neutral, without the US having slipped into recession. When considering this question, it is important to note that it is national savings that matter when considering the savings/investment balance. Chart II-18 highlights that the US government massively dissaved during the pandemic. Panel 2 of Chart II-18 shows that the US private sector financial balance, defined as the difference between gross private savings and gross private domestic investment, surged during the pandemic but has since fallen well below the average level seen during the last economic expansion. From our perspective, this underscores that there is no savings/investment basis to argue that the neutral rate is meaningfully different than that of trend growth. However, based on the FOMC’s summary of economic projections, the Fed does not share this view. Chart II-19 highlights that the highest Fed estimate of the funds rate over the longer run is 3.3%, well below that of trend economic growth. The chart also highlights that investors have recently raised their estimate of the neutral rate, but it is still below prevailing estimates of potential growth. Chart II-19The Fed Still Believes In The New Neutral Narrative, Which Could Have Very Important Implications For Monetary Policy As Inflation Falls Our neutral rate view will likely have important implications for long-maturity government bond yields in the aftermath of the next US recession. But over the coming year, the more important question for investors is whether the Fed’s low neutral rate view will act as a basis for the Fed to cut interest rates back to what we would consider to be stimulative levels before a recession has begun. As we have noted in several recent reports, US monetary policy is now tight, even based on our view of the neutral rate of interest; and it is on this basis that we have been recommending that investors position their portfolios conservatively over the coming year. As we discussed in our February 2023 Special Report,5 we can envision a scenario in which inflation decelerates enough to make the Fed feel comfortable easing monetary policy from current levels, but to a point that is still tight according to its estimate of the neutral rate of interest. Table II-2 highlights that a monetary policy rule that has been cited by Fed officials and by researchers would prescribe what we would consider to be easy monetary policy if core PCE inflation were to fall below 2.9%, which is (for now) in line with its current three-month annualized rate of change. Table II-2A Dovish Taylor Rule Would Prescribe Sub-4% Policy Rates If Core PCE Inflation Is Below 3% Chart II-20The Real Short-Term Interest Rate Is Already Positive Based On Recent Core Inflation This truly cannot be ruled out as a possible outcome, because the basis for the Fed’s elevated interest rate forecast relative to what monetary policy rules would prescribe may prove to be ephemeral. The Fed may believe that the neutral rate of interest is temporarily higher, a perspective that could quickly change as inflation slows further and the labor market weakens. Or it may be using simpler perspectives, such as the idea that the real fed funds rate should be positive to return inflation back toward its target, which has already occurred based on shorter-term measures of inflation (Chart II-20). Any meaningful indications that the Fed is likely to cut the fed funds rate before a recession has begun would have a significant impact on our recommended cyclical investment strategy. We would very likely recommend raising exposure to risky assets in this scenario. We discussed this possibility in our February report and concluded this is not yet a likely scenario, but we will continue to monitor the odds of this potential event throughout the year. Over the longer run, however, we think this scenario would risk quite a negative outcome for both equity and fixed-income investors. A scenario in which the Fed inadvertently moves monetary policy back into stimulative territory would substantially raise the odds that long-term inflation expectations would cease to become well-anchored unless they had fallen from current levels by that point: that is, it would significantly increase the chances of elevated structural inflation. This is what Martin Barnes, BCA’s former Chief Economist, outlined in our July 2022 Special Report.5 Structurally higher inflation would obviously be negative for investors with long-maturity government bond positions; we suspect that it would also be negative for profit margins (as it was during the late-1960s and 1970s) and would imply higher risk premia for both stocks and bonds. Investment Conclusions It is the view of the Bank Credit Analyst service that the Fed’s very low neutral rate is folly rather than fact, which results in a complicated investment reality. Over the coming 6-12 months, it raises the odds that the Fed will unknowingly return monetary policy to stimulative territory in response to a significant further easing in inflation, even if inflation has not yet returned to the Fed’s 2% target and the unemployment rate has not risen significantly. If this were to occur before a US recession has begun, it would extend the economic cycle, and would validate expectations of positive earnings growth over the coming year. It would also result in higher equity multiples in response to the combination of lower long-maturity bond yields and a likely decline in the equity risk premium. Under these circumstances, pro-risk positioning, at least for a time, would be clearly warranted. However, this scenario would also significantly raise the risk of unmoored long-term inflation expectations, which would mean that inflation would likely come in persistently above the Fed’s target without a materially higher fed funds rate and a meaningful period of the unemployment rate above NAIRU. This scenario implies that the next US recession would be more severe than we currently expect, and would likely be devastating for both equity and bond prices. Until we see clear signs that the Fed is likely to bring monetary policy back into easy territory outside of the context of a recession, our neutral rate views, in conjunction with the current level of the fed funds rate, argues for a conservative investment stance over the coming 6-12 months. As noted, we remain attuned to the possibility that the Fed will significantly reduce interest rates on the basis of its very low neutral rate view, but the odds of this outcome are low and have recently fallen. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst APPENDIX 1 Solow Growth Model And The Neutral Rate Of Interest Footnotes 1     Please see Global Investment Strategy "Are High Debt Levels Deflationary Or Inflationary?," dated February 15, 2019, available at gis.bcaresearch.com 2    Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 3    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 4    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "What Will It Take For The Fed To Cut Rates?" dated January 26, 2022, available at bca.bcaresearch.com 6     Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com

Since 1970, the track record of US housing recessions as the ‘canary in the coal mine’ for economic recessions is a perfect four out of four: 1974; 1980; 1990; and 2007. If this perfect track record continues, the current US housing recession presages an economic recession that starts in 2023. We discuss the investment implications.

The risk of a recession in 2023 is being supplanted by the risk of another inflation wave. We will turn more defensive on equities if it continues to look like inflation is making a comeback.

Ironically, increased confidence that the economy can withstand higher bond yields may be necessary to lift yields to a level that is actually detrimental to growth. Thus, until more investors are convinced that a recession will be averted, a recession will be averted. Remain tactically bullish on stocks for now. A more defensive posture will likely be necessary later this year.

The Fed is betting that the usual non-linearity of unemployment is different this time, but so far, there is nothing to suggest that it is different. We discuss the key signposts to watch out for, plus the implications for interest rates and asset allocation.

Financial markets were taken on a wild ride between Wednesday and Friday of this week, with hugely important monetary policy meetings in the US, euro area and UK along with a rash of economic data. Despite all the news, noise and market volatility, the underlying message for monetary policy and bond yields in the US, euro area and UK is unchanged.

The US economy will experience a period of benign disinflation over the next few quarters. Beyond this goldilocks period, either the economy will slip into a mild recession in 2024, or more ominously, a second wave of inflation will prompt the Fed to slam on the brakes, leading to a deep recession.

Special Report

This week’s Special Report goes over the structural problems facing the UK economy and our outlook for UK gilts and the sterling following turbulent moves in 2022.

Special Report

In this Special Report, BCA Strategist Ritika Mankar highlights that India may prove to be a sanctuary of safety in what promises to be a volatile 2023. Indian equity outperformance could continue, as India ends up offering relatively high growth at a time when EMs at large must contend with the effects of declining exports, high global interest rates, and exhausted fiscal stimulation capabilities.

Special Report

Highlights Market expectations for Fed rate cuts later this year reflect either an extremely mild US recession, or a nonrecessionary scenario in which inflation falls rapidly back toward the Fed’s target. In the case of a true recession, even a historically mild one, the Fed will likely cut interest rates meaningfully below what is priced into the OIS curve – to 1% or lower. It is plausible that the Fed could ease monetary policy this year before the US economy begins to contract, because the Fed wrongly believes that the neutral rate of interest is just 2.5% – well below the current policy rate. Monetary policy rules also point to interest rate cuts even if the Fed’s current inflation and unemployment rate forecasts for this year come to fruition. However, several conditions would need to be met for the Fed to consider easing monetary policy, meaning that the prospect of nonrecessionary rate cuts this year is possible but not especially likely. Given that US monetary policy is currently tight, a high bar for the Fed to cut rates supports a defensive stance. Investors should remain underweight stocks versus bonds in a multi-asset portfolio over the coming 6-12 months. Feature Chart II-1The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year Based on the shape of the OIS curve, investors are projecting that the Fed will cut interest rates in the latter half of this year. Chart II-1 highlights that the OIS curve peaks at 4.9% as of this summer, falling to 4% by the end of this year. The common interpretation of this is that the OIS curve reflects investors’ expectations of a mild recession. However, an alternative explanation is that financial markets are priced for a soft-landing scenario, in which the Fed cuts rates back toward its neutral rate estimate in response to declining inflation before the US economy tips into a recession. In this report, we explore what it will take for the Fed to cut interest rates in both a recession and non-recession scenario for this year. In the case of a true recession, the Fed will not only cut the fed funds rate, they are also very likely to cut it meaningfully below what is priced into the OIS curve – to 1% or lower. And, while it is plausible that the Fed could ease monetary policy this year before the US economy begins to contract, it does not seem particularly likely, given that several conditions would need to be met. For now, our conclusions continue to support a defensive stance, arguing that investors should remain underweight stocks versus bonds in a multi-asset portfolio. Fed Rate Cuts: The Recession Scenario The most obvious scenario in which the Fed cuts interest rates is one in which the US economy slips into a recession, which we believe is more likely than not to occur at some point over the coming year. Chart II-2 highlights that the Fed has always eased monetary policy following the onset of recession in the post World War II (WWII) environment. Many investors would argue that the recession scenario is effectively what is being priced into financial markets: 12-month forward earnings have modestly declined, consensus economic forecasts call for at least one quarter of negative growth in 2023 and a rise in the unemployment rate to 4.8%, and the OIS curve is now pricing in 225 basis points of interest rate cuts from Q2 2023 to Q2 2024 (Chart II-3). Chart II-2The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur Chart II-3Consensus Economic Forecasts Call For An Extremely Mild Recession This Year   As such, some argue that, based on these apparent expectations of a very mild recession, earnings are not likely to decline significantly from current levels and the equity market has already priced in upcoming economic weakness. Effectively, the consensus view is pricing in what the Fed is projecting in its most recent Summary of Economic Projections. We think that is not a likely occurrence for the following reasons: Following WWII, the US unemployment rate has never risen less than 2% during a recession (Chart II-4). What the market is calling a “mild recession” would actually be the mildest recession in US history, by a nontrivial amount. Peak-to-trough declines in earnings during recessions are typically between 10-20% (Chart II-5), versus the 3-4% decline that has occurred over the past year. And while it is true that 12-month forward EPS only recorded a single-digit decline during the 1990-91 recession, that decline occurred against the backdrop of meaningfully lower profit margins compared to the present day; there was thus less of a risk to earnings at that time from margin compression. Chart II-4The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History Chart II-5US Earnings Per Share Do Not Reflect A Recession       The equity risk premium has fallen, rather than having risen, as monetary policy has become tight (Chart II-6). Within the bond market, the level of interest rates priced into the OIS curve following the onset of rate cuts is very likely too high for a recession scenario. 1-year/1-year forward bond yields currently trade at roughly 3.7%, which is barely stimulative based on our view of the neutral rate of interest and still tight based on the Fed’s neutral rate view as well as the market’s. As we wrote in our September Special Report,1 the historical experience of recessions suggests that the Fed will cut the policy rate close to the zero lower bound (Chart II-7). That is based on the historical level of interest rates relative to potential growth or average realized nominal GDP growth. It is possible that the Fed will cut rates closer to 1%, but we suspect that this would most likely only occur in a scenario wherein core inflation was slower to return to target levels than the Fed expects. Absent another supply-side shock over the coming 12-18 months, we believe that the combined effect of waning pandemic-related and supply-side driven inflation, decelerating house prices and rental rates, and weak aggregate demand in the case of a recession is more likely than not to bring core inflation back to, or even below, target levels. Chart II-6The US Equity Risk Premium Is Too Low Given Recessionary Risks Chart II-7The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory The historical experience of Fed rate cuts during recessions shown in Chart II-7 is also supported by two monetary policy rules when considering the Fed’s current neutral rate assumption. Chart II-8Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession The most well-known monetary policy rule is the Taylor Rule, but FOMC officials have more commonly spoken about another rule called the balanced-approach rule with shortfalls (which is, itself, a version of the original Taylor Rule). In this version of the rule, the policy rate is equal to the Fed’s inflation target, plus the real neutral rate of interest, plus the inflation gap (times a multiplier), plus the output gap when the gap is negative. This one-sided consideration of the output gap is somewhat compensated for by an inflation gap multiplier that is larger than 1 (typically 1.5, versus 0.5 in the Taylor Rule). In short, compared to Taylor Rule, the balanced-approach with shortfalls rule will produce a policy rate that is the same as that produced by the Taylor Rule for any given level of inflation when the unemployment rate is at NAIRU, but less than the Taylor Rule as the unemployment rate deviates from NAIRU in either direction. As such, the balanced-approach rule with shortfalls is a strictly more dovish monetary policy rule than the Taylor Rule. Assuming a recession scenario in which core PCE inflation falls to 2% and the unemployment rate rises to 5.5%, the balanced-approach rule projects a -0.5% policy rate (Chart II-8). Using the same assumptions for the Taylor Rule and deriving the output gap through Okun’s law, the policy rate is projected to be 1%. A simple average of these two approaches is 0.25%, which is effectively the Fed’s lower bound. This underscores that investors should shift heavily into a long duration stance in response to concrete signs that the US economy is indeed veering into recession, which we expect to become evident in the labor market over the coming few months. Fed Rate Cuts: The Nonrecessionary Scenario As noted above, the view of most investors is that financial markets are pricing in the likelihood of a US recession, and that the OIS curve reflects what investors believe is the likely recessionary interest rate path. Chart II-9According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight Another possibility is that investors expect nonrecessionary rate cuts, as the Fed responds to easing inflation by lowering the policy rate closer to its estimate of neutral – what the Fed and many investors refer to as a “soft landing”. That would still be consistent with our interpretation of the yield curve that we noted in Section 1 of our report, and the muted decline in 12-month forward S&P 500 EPS. The core basis for the nonrecessionary rate cut view is the fact that the Fed believes the neutral rate of interest is just 2.5%, which is well below the current policy rate (Chart II-9). In fact, as we have highlighted in past reports, monetary policy is the tightest it has been since the 1980s based on the Fed’s neutral rate view. We strongly disagree with the Fed’s estimate of the neutral rate. But from a strategy standpoint, it is important to predict how the Fed will act, rather than how it should act. Unless the Fed revises its neutral rate estimate higher, it is possible that they will choose to lower interest rates before a recession has begun, in response to an “immaculate disinflation” scenario in which inflation decelerates rapidly back toward its target. The key question is how low inflation would need to fall before the Fed becomes comfortable easing policy. Charts II-10 and II-11 highlight what the balanced-approach with shortfalls rule would imply in view of the Fed’s most recent forecasts from the summary of economic projections, as well as in a true soft landing scenario wherein the unemployment rate rises to just 4% and inflation returns completely back to the Fed’s 2% target. In the first case, the balanced approach rule prescribes a policy rate of 3.6%, close to 160 basis points below what the Fed’s policy rate projection for the end of this year. In the second case, given a closed inflation gap and an unemployment rate at NAIRU, the rule prescribes a policy rate that is in line with the Fed’s neutral rate estimate of 2.5%, approximately 260 basis points below what the Fed projects for this year. Even the Taylor Rule would point to rate cuts in both scenarios, projecting a policy rate of 4.1% and 2.5%, respectively. Charts II-10 and II-11 make it clear that the Fed has stated plans to maintain very high policy rates compared to what typical monetary policy rules would advise. Why is this the case? There are three possible answers. Chart II-10Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed’s Economic Forecasts Chart II-11A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed’s Neutral Rate View     The first is simply that monetary policy rules are not part of the Fed’s reaction function and have no bearing on monetary policy. This is possible, but not a particularly likely explanation given that Fed officials occasionally refer to them and that they are structured in a way that at least theoretically captures the Fed’s reaction function. The second possible answer is related to the fact that the fed funds rate significantly undershot what monetary policy rules would have prescribed in 2021. It may be that the Fed is attempting to compensate for this deficit when setting interest rates over the coming year, especially given how significantly some measures of inflation expectations have risen. In fact, this perspective is theoretically supported by the idea of the modern-day Phillips Curve. We noted in our January 2021 report that if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero.2 Given that the output/jobs gap is fundamentally determined by the stance of monetary policy, the Fed may see its failure to raise rates in 2021 as having contributed to too long a period of very strong employment, which needs to be balanced by a period of “too-high” interest rates. Chart II-12There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking Additionally, recent work from the IMF on the risk of a wage-price spiral has shown that the magnitude of the monetary policy response required to prevent such a spiral is determined by whether long-term inflation expectations are primarily backward or forward looking.3 Chart II-12 provides good evidence that long-term inflation expectations have recently been forward looking, but the Fed may believe (reasonably so) that this is less likely to be true the longer that inflation remains above its target level. Finally, the third possible answer explaining why the Fed’s rate projections this year are so much higher than monetary policy rules would prescribe is that the Fed is simply jawboning. The goal of jawboning the market would be to convince economic agents to set lower prices and accept lower wage growth to ensure that inflation does indeed return to target, such that the Fed either does not actually need to raise short-term interest rates to the level they are projecting, or must quickly lower them once their unemployment rate and core PCE inflation projections materialize. As we noted in Section 1 of our report, we do not think that the latter scenario is likely. However, if it does occur, it could enable the US economy to avoid a recession in 2023, and would likely alter our current asset allocation recommendations in the direction of increasing risky asset exposure on a 6-12 month time horizon. R-Star Wars? Chart II-13The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking As noted above, the core basis for a nonrecessionary rate cut view is the fact that the Fed (wrongly) believes the neutral rate of interest is meaningfully below the potential rate of nominal economic growth. This view has been heavily influenced by the revival of the theory of secular stagnation by Larry Summers in the fall of 2013 (Chart II-13). Thus, the expectation of some investors that the Fed will ease monetary policy before a recession begins will be undercut if the Fed were to raise its expectations for the neutral rate, or were to act as if it believed that R-star might be higher, even if those beliefs were not reflected in the FOMC’s Summary of Economic Projections. While the Fed has made no indication that this is the case, recent comments from Summers himself during a recent interview suggest that the Fed’s longer-run interest rate projections may increasingly come under pressure: “The thirty-year story has been declining interest rates and the idea that we're moving into an era of low interest rates. That was certainly the thesis that I was pushing with the idea of secular stagnation prior to COVID; that has been the basis for a large amount of economic thinking. The idea that we are going to return to [that environment] is a kind of orthodoxy baked into markets. You see it when the Fed predicts a half a percent neutral real rate, you see it in breakevens on inflation in the low 2s, you see it in a 10-year rate in the 3.7% range. And that might be how things play out. The forces of secular stagnation – demography, inequality, lower priced capital goods – all of that are strong. But my guess is that just as those who during the Second World War predicted that when the war ended we would return to secular stagnation and a sluggish low interest rate economy turned out to be wrong, that is going to be true this time around. I think we are in a new era of much higher government debt ratios. We are in an era, including because of national security spending, of substantially larger budget deficits. We are in an era of much higher investment demand because of resilience investment and reshoring, and because of green energy transformations that are going to happen all over the world. At the same time, the disinflationary shock of billions of people in emerging markets joining the global labor pool and applying disinflationary pressure – that is surely not going to continue at the same rate [as over] the last several decades. And it may, given developments in China, actually go into reverse. There is going to be [an increase] in uncertainty and I think [that is] likely to translate into increased term premiums. So my guess is that this is going to be remembered as a “V” year, when we recognized that we were headed into a different kind of financial era with different kinds of interest rate patterns.” Larry Summers, Bloomberg TV, January 6, 2023 Some of Summers’s comments relate to the belief that nominal interest rates will be higher in the future because of structurally elevated inflation, but some of what he expects would relate to a higher real neutral rate, particularly the idea that global investment demand will be stronger because of increased defense spending, resilience investment / reshoring, and green energy projects. A broader discussion of whether the factors that Summers raised are likely to materialize will likely be the subject of future BCA Research reports. But for now, the key point is that the idea of a low neutral rate of interest may become increasingly controversial over the coming months and years, implying that investors cannot necessarily rely on the Fed’s low neutral rate view to act as a strong basis for significant rate cuts over the coming year outside of the context of a recession, even if inflation slows significantly. Investment Conclusions We noted above that there are two scenarios in which the Fed could cut interest rates over the coming year. The first scenario involves a recession, which we think is the most likely economic outcome over the coming year. However, were a recession to occur, it is likely to be more severe than investors currently expect, because what the market is calling a “mild recession” would actually be the mildest recession in US history, by a nontrivial amount. Based on the historical experience of recessionary interest rate cuts, as well as what is implied by monetary policy rules, we expect the Fed to cut the fed funds rate to 1% or lower in a recessionary scenario. This underscores that investors should shift heavily into a long duration stance in response to concrete signs that the US economy is indeed veering into recession, which we expect to become evident in the labor market over the coming few months. The second rate cut scenario involves the Fed easing monetary policy before the economy veers into contractionary territory. This is a plausible scenario given that the Fed believes the neutral rate of interest is just 2.5%, meaning that the current stance of monetary policy is extremely tight according to the Fed’s view. Monetary policy rules point to interest rate cuts even if the Fed’s current inflation and unemployment rate forecasts for this year come to fruition. The latter underscores that the Fed could cut interest rates this year in a nonrecessionary context if all of the following conditions are met / become true: Core PCE inflation falls below the Fed’s 2023 forecast of 3.5% Inflation expectations remain well anchored or decline from current levels The Fed does not believe that it needs to compensate for “too-low” interest rates in 2021 with a period of “too-high” interest rates The Fed does not upwardly revise its real neutral rate view or set monetary policy as if R-star were higher than the FOMC currently projects Were this nonrecessionary rate cut scenario to materialize, it would likely cause us to change the investment recommendations that we outlined in our 2023 Annual Outlook. Evidence that the Fed is shifting toward rate cuts prior to the onset of a recession would still cause us to recommend a long duration stance (as the Fed would be lowering short-term interest rates), but we would likely recommend increasing exposure to risky assets back to overweight. Falling long-maturity bond yields would support equity multiples, and the avoidance of a recession would almost certainly point to positive earnings growth, the combination of which would likely lead stocks to outperform bonds over a 6-12 month time horizon. For now, however, we do not find the prospect of nonrecessionary rate cuts to be especially likely, meaning that interest rates are likely to fall later this year because of a recession rather than in the context of a “soft landing”. This supports a defensive stance, indicating that investors should remain underweight stocks versus bonds in a multi-asset portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst “The Fed Funds Rate, Bond Yields, And The Next US Recession,” dated August 25, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December, 2020, available at bca.bcaresearch.com 3  “Wage Dynamics Post–COVID-19 and Wage-Price Spiral Risks,” International Monetary Fund World Economic Outlook, October 2022