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

"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.