"... A Recession Has Always Followed": Is This The Real Reason The Fed Is Suddenly Panicking

Tyler Durden's picture

"Why is the Fed so desperate to raise rates and tighten financial conditions? Why has the Fed shifted from a dovish to a hawkish bias?"

That is the question on every trader's, analyst's and economist's mind in the past month. Is it because the Fed is suddenly worried it has inflated another massive equity bubble (major banks now openly warn their clients the market is in frothy territory, if not inside a bubble), or is the Fed just worried that it will fall too far behind the curve and be unable to regain control of the economy once inflation spikes, without creating a recession (in what will soon be the second longest, if weakest, economic expansion of all time).

This is also what BofA's chief economist Ethan Harris tried to answer over the weekend, when he recalled that while from 2013 to 2016 the Fed seemed to have a "dovish bias" signaling a slow exit from super easy monetary policy, but pausing at any sign of trouble, this year the Fed appears to have shifted to a "hawkish bias:" signaling a slow exit, but only pausing if the outlook changes significantly. He says that this was most evident when the Fed hiked rates and signaled balance shrinkage at its June meeting despite weak growth and inflation data.

Why the change of Fed feathers? In BofA's view, three factors are at play, in increasing order of importance.

First, the Fed is worried a bit about financial stability and overheating markets. However, the bank puts a relatively low weight on this argument, as Chair Yellen and her allies have repeatedly underscored the idea that macro prudential policy is the first line of defense against asset bubbles and monetary policy is a distant "Plan B", although to this we can add that macroprudential policy has yet to demonstrate its effectiveness in preventing even one asset bubble.

The second reason for the Fed's hawkish turn is that it is probably encouraged by how easily the markets have absorbed its forecasts. Since the start of the year the Fed has hiked more than expected and has accelerated its balance sheet shrinkage plans and yet, as Goldman has repeatedly noted and all other banks have promptly followed, stocks have rallied while bond yields have been little changed on net. If a steady exit is causing no apparent pain, why not continue? (for one answer, read the latest note from Deutsche Bank on Conundrum 2.0)

Here Bank of America is worried that the Fed is being lulled to sleep: the bond market is pricing in only about a 50 bp increase in the funds rate by yearend 2018 compared to the FOMC median forecast of 100 bp. Moreover, despite firming plans for balance sheet shrinkage, bond term premia have actually declined (Chart 5). This suggests the markets don't entirely believe the Fed's hawkish message, and with good reason: every time the Fed has blustered on the hawkish side in the past, it has quickly retreated the moment markets sold off even modestly. Although this time, Harris warns that if the Fed follows through on its plans, he sees the potential for a tightening in financial conditions.

Which brings us to what BofA believes is the third, and most important, reason for the Fed's change inoutlook: a shift in the Fed's risk rankings. As BofA explains, for years the focus was getting inflation back to target. They did not want a recession to occur before inflation (and interest rates) had normalized. Now the focus has shifted more to the risk of undershooting on the unemployment rate, which has fallen well below even the Fed's revised estimate of NAIRU.

As several Fed officials have pointed out, undershooting full employment can and will be problematic. Dudley recently noted: "if we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation." He continued, "then the risk would be that we would have to slam on the brakes and the next stop would be a recession."

On a similar vein Boston Fed President Rosengren argued last summer that after hitting a cyclical low, "there are no episodes in which unemployment rose a bit and remained stable at its natural employment rate. Rather, a recession has always followed" as shown in the chart below.

Rosengren concluded: "The lesson is that policymakers should avoid significantly overshooting their best estimates of the natural rate of unemployment."

Which brings us to what BofA dubs the "nightmare scenario for the Fed": the mid-1960s. US inflation averaged just 1.3% from 1952 to 1964, resulting in a very benign consensus around the inflation outlook. Economists generally assumed that NAIRU was 4% or less and that there was a stable long-term trade-off between unemployment and inflation: if the unemployment rate dropped below NAIRU only a small move higher in inflation was expected. The next 15 years offered a rude awakening. Core inflation started to surge in 1965.

Digging into the data, the acceleration was broad-based, with rising prices of both goods and services. Harris is convinced that "the Fed must be concerned-in the back of its mind-about such a "rusty gate" scenario."

As Harris concludes, while it is unclear whether core inflation will move back to target or not, a further drop in the unemployment rate seems likely, shifting the risks around Fed policy.

Fed officials believe the economy already has pierced or inevitably will pierce NAIRU. However, they are feeling their way forward: they can only be sure they have breached NAIRU if core inflation has moved decisively higher. The danger for the Fed is that it learns, with a lag, that the economy is say a percentage point below NAIRU. At this stage it would face a very difficult juggling act: stopping the rise in inflation will require raising the unemployment rate by at least a percentage point, but that means a high risk of recession. Clearly that is a challenge they want to avoid.

BofA's advice to advice to investors: "keep a close eye on the labor market." Meanwhile, our advice to investors is keep an even closer look at the stock market, because the real test for Yellen and company is if and when the market does take the Fed seriously, if a correction of 10% does not lead to an immediate jawboning of rate cuts or more QE, then the BTFDers, quants and algos may finally be truly on their own for the first time in nearly a decade.

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Raffie's picture

We long over due for a more economic hard times.

Erek's picture

"...stopping the rise in inflation will require raising the unemployment rate by at least a percentage point, but that means a high risk of recession..."

WTF? We've been in a recession for how many years now?

Creepy_Azz_Crackaah's picture

Is this using the real unemployment numbers or the fake unemployment numbers?

Just change the unemployment numbers again. Problem "solved."

hedgeless_horseman's picture

 

Everytime I see the so-called business cycle displayed like Chart 4, I cannot help but think...

Since 1913
The Federal Reserve Bank
privatize the gains,
socialize the losses.

Captain Chlamydia's picture

The president following a double term president,  has a financial crisis. That has been the case for the last 50 years.....good luck mr Trump ! 

AVmaster's picture

Or D: They are intentionally trying to crash the economy in order to make trump and the republicans look bad and give the democrats something to campaign on in 2019/20

 

Because people really are that stupid and will most certainly fall for it... It has happened before, a couple of times... The great depression is one of them and it resulted in a snowball of shit that is STILL fucking us in the ass today(hint: Social Security for starters)....

Stuck on Zero's picture

The Fed is not worried. The BLS will make up any numbers desired to make the Fed's performance look great.

jerry_theking_lawler's picture

Great observation!! Then why not limit President's to 1 term only...that will stop financial crisis, correct?

TeethVillage88s's picture

"...stopping the rise in inflation will require ..."

- Real data
- Real Honesty

Can't be done with this Congress nor with this President.

- War, War, War!
- Tora, Tora, Tora!

Now Fuck Off!! Edit1: not you Poster. Lobbyist, Wealthy, Foundations, Survey Orgs, Congress, Political Machines, MSM, CNN, TV News, Cable News, AP, Reuters...

Edit2: to ur question: in 2007 we paid $42 Billion for Food Stamps... today $73 Billion. AND in whatever the number of people on food stamps in the 2008 Crisis... today there are 46 Million... much more than in Great Depression!

NoDebt's picture

"We long over due for a more economic hard times."

The last 8 years hasn't been enough for you?

 

Raffie's picture

I'm talking like a forest fire to burn up all the crap in the forest to allow new growth to take place.

 

Secret Weapon's picture

Careful there.  You will make Oldwood break out in a sweat talking like that.

DarthVaderMentor's picture

The last eight years have been absolutely great if you're a federal government bureaucrat.

GUS100CORRINA's picture

"... A Recession Has Always Followed": Is This The Real Reason The Fed Is Suddenly Panicking

My response: BRING IT ON!!!! Look forward to seeing how the CBs and politicians are going to explain the pain to the American public when it occurs.

Paul Kersey's picture

" the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation."

More goldmanite (Dudley) horseshit. What difference does a synthetic low unemployment rate make, when there is a fully organic underemployment rate and a close to historically high rate of working age men no longer participating in the workforce? What kind of inflation is Dudley expecting, when folks don't have the money to buy shit. 69% of Americans don't even have a thousand bucks in the bank.

The Fed's only raising rates, so that it can lower rates, again, when the economy is totally constipated. The only inflation we've got, we get from the rentier monopolies and bankster wealth extractors, who are pumping up asset prices, rents, college tuition, insurance premiums and medical costs.

hongdo's picture

"The only inflation we've got, ..... asset prices, rents, college tuition, insurance premiums and medical costs" and houses,  taxes, fees, tolls, cars, food....

So that's the only inflation we've got?  What else is there?  Oh yeah clothes are cheap at Ross.  Airfares are down too but that's a kind of reverse hedonic adjustment for worse service.

What are you buying that's still cheap?

SybilDefense's picture

The elite, lucky enough to hold all the free printed money in their dry powder locker are inflating the things you mention as it is those things they own or control.  Once the free money trickles down to people, it is because these elite need to loosen their death grip on their own money stores, at which time the circulating M supply will spike inflation as the small business owners will then want their share of the free money through raising all consumers prices.  Let's not be fooled that simply because there may be easy money dropped from the sky that the value of that money by the time people get to spend it won't be deflated in direct proportion or more to the inflated cost of living.

Nothing ever has value if it is given, and not earned. If every American would be given $100k tomorrow, their wealth would remain the same or more likely decrease as a fool and his money are easily parted, and there would be an increase in the ways in which that scenario would occur, one being inflation. 

In summary: Gov gets theirs>Corp USA gets theirs> small biz gets theirs> people think they get their share = Gov gets ours. Print, rinse repeat

SybilDefense's picture

The elite, lucky enough to hold all the free printed money in their dry powder locker are inflating the things you mention as it is those things they own or control.  Once the free money trickles down to people, it is because these elite need to loosen their death grip on their own money stores, at which time the circulating M supply will spike inflation as the small business owners will then want their share of the free money through raising all consumers prices.  Let's not be fooled that simply because there may be easy money dropped from the sky that the value of that money by the time people get to spend it is deflated in direct proportion or more to the inflated cost of living.

Nothing ever has value if it is given, and not earned. If every American would be given $100k tomorrow, their wealth would remain the same or more likely decrease as a fool and his money are easily parted, and there would be an increase in the ways in which that scenario would occur, one being inflation. 

Singelguy's picture

Not only do they have less than $1000 in the bank, they likely have at least $10,000 in credit card debt, plus a big mortgage and car loan. That is the bigger problem.

HRClinton's picture

What a wicked price we pay, when first the Fiat Ponzi we play. 

Fiat bubble.  Toil and trouble...

order66's picture

Yawn. Buy first ES bottom wick in the morning and sell vol. Sell first lower low in the afternoon. Rinse, repeat.

Yen Cross's picture

  This conundrum is amplified by magnitudes for the ECB and euro area, who can't even discuss tapering, without bond coupon values crashing.[ %rates exploding]

shizzledizzle's picture

I think Mario learned his lesson. 

ParkAveFlasher's picture

I'm confident; Yellen does a pretty good job.

Erek's picture

What are you smoking? I want some, too!

CPL's picture

What's the difference between pretty good sex and great sex?  You'll actually remember great sex.  She won't be remembered.

Paul Kersey's picture

She will be remembered, but it won't be for doing a "pretty good job".

Glyndwr will return's picture

Can we please dispense with the myth that there are actually any traders at the present time.

There are no markets, so how can you have traders?

cougar_w's picture

"risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation."

Notice, that's really weird use of the word "crash".

Crypto-World-Order's picture

The recession never left for most, because most are financially illiterate.

cognitive dissident's picture

The corrupt Fed never ever panics. They only party. While the rest of us pay for It.

Get it straight.

hongdo's picture

 I heard Bernanke is taking responsibility for his mistakes and is living in a tent on the street in LA.

Joebloinvestor's picture

They only manipulated the shit out of it when they liked the administration.

 

I hope Trump gets rid of the whole lot of them when it explodes.

Vlad the Inhaler's picture

That's what I've been saying, their biggest fear is that the bond market grabs them by the balls.

DarthVaderMentor's picture

Remember, an increasing number of them including Ole Yeller have no balls.....

Conax's picture

She does have a couple impressive goiters down there.

SDShack's picture

There is no bond market. The Fed and their proxies had control of about 1/3 of the bond market years ago. There were lots of ZeroHedge articles to document it. I suspect that if an honest audit of all the off-balance shit was done, the net effect is they actually control over 1/2, so the bond vigilantes have been neutralized. Just look at Europe for evidence. Did Greece and Cyprus implode the system, or did the system implode Greece and Cyprus? Same for Govt. Motors Bond Holders. Bottom line is when the system begins to implode, TPTB will change the rules so they win, not the bond vigilantes. There have been no markets since at least 2008.

TimmyM's picture

Bullshit
I don't have time to list all the fucking ways now is different than 1965 for these idiots.

Yippie21's picture

Who the hell thinks these people know what the hell they're doing??  It's all BS.  The FED is one of the most specious inventions.  Hasn't done a damn thing except make cycles worse and the "inside" folks rich.

california chrome's picture

"Why is the Fed so desperate to raise rates and tighten financial conditions? Why has the Fed shifted from a dovish to a hawkish bias?"

Because the Fed can say "I told you so" the minute after Trump re-appoints Yellen for another term and she implodes the market on Trump's watch and the libtards have another fake reason to impeach POTUS.

SDShack's picture

Inflation took off in the late 60's because the baby boomers were just starting to enter adulthood and begin consuming en masse. This predicated the entire Fed shift of target inflation to be around 3-4% which was double the historical norm. As the baby boom credit demand began to slow in the 90's the Fed had to artificially stimulate credit demand and so Glass-Steagal was repealed and that led to the Dot.com bust, and then the 2008 Financial Bust.

Everything the Fed has done is to try to maintain the 3-4% target inflation which is really 3-4% credit/debt growth in the midst of shrinking demand brought on by demographics and outsourcing jobs to the 3rd world. The first canary singing was Japan. With negative growth and no immigration, the only option for Japan was massive govt stimulus, i.e. debt. The second canary was Europe, again with negative growth, so they tried massive govt spending with massive immigration with disasterous results. Now the USSA and China are starting to sing, and the Fed is realizing their credit growth Ponzi sheme is in danger of collapsing due to aging baby boomers downsizing versus dead end millenials that can't leave home.

This is probably why the Fed is so schizoid with their policies because they realize they can't keep the 50yr Ponzi party of 3-4% credit growth/debt going with downsizing boomers and broke unmotivated millenials. Hence the Fed is telegraphing the need to reduce their balance sheet to better align with real world credit growth/debt. I suspect that the biggest worry the Fed has isn't inflation, but deflation because they know the world consumer is tapped out, and there are no real opportunities for true organic growth that could result in real wages or take home pay increasing, and thus demand must drop. Couple that with real inflation of necessary items to live (food, housing, energy, healthcare) and the sheeple will require more govt assistance to offset the shortfall. So expect more govt debt like Japan and Europe as that is all TPTB have got left.

It's a race to the bottom as every central bank devalues their currency in a Ponzi shell game that ultimately will have to collapse. But probably not until the masses are literally starving in the streets and are so desperate that they are willing to risk revolution to survive. Unfortunately, the "order" that comes after that will probably be even worse.

MrSteve's picture

This is a terribly misguided recitation of economic cause and effect history since the 1960s, but I don't dispute the end results will be as bad as you suggest. Maybe a lot worse...we see that now in Venezuela and in the Arab Spring.

Mentaliusanything's picture

THIS ^^^^^^ (above Mr Steve)