After Fed Chair Powell's latest FOMC presentation, and also following his speech yesterday, the general market consensus was that the Fed is on auto-pilot for the conceivable future, at least until something changes. But what could make the FOMC speed up the pace of tightening? What would make it pause? And how will the Committee know when it’s done? While comments from Chairman Powell offered some answers to these questions, Goldman has conducted an analysis on the FOMC’s decisions to accelerate, pause, or conclude the 1994-1995, 1999-2000, and 2004-2006 hiking cycles offer additional clues.
First, a quick reminder of what Powell said in his press conference following the September FOMC meeting: first, Powell offered some guidance on what it would take for the Fed to deviate from its projected policy path, when he said that potential triggers for a pause include either a “significant and lasting correction in financial markets or a slowing down in the economy that’s inconsistent with our forecast.” The main trigger for raising rates more quickly, Powell said, would be if “inflation surprises to the upside.”
So far so good; however for some additional clues about what the Fed would need to see to accelerate, pause, or conclude its hiking cycle, Goldman looked back at the last three hiking cycles, and identified moments where the Fed accelerated, temporarily paused, or concluded its rate hikes during the last three (1994-1995, 1999-2000, and 2004-2006) hiking cycles, as shown in the chart below. Goldman then investigates the rationale for these policy decisions below by looking back at the statements, minutes, and transcripts from FOMC meetings at the time.
1. Accelerating the hiking cycle
While hardly a realistic outcome this time around absent a surge in average hourly income above 3.0%, the 1994-1995 hiking cycle provides one example where the Fed picked up the frequency of rate hikes (an intermeeting hike in April 1994) and two where it increased the size of its rate hikes (50bp in May and 75bp in November 1994).
According to Goldman, transcripts from FOMC meetings at the time indicate that the Committee worried that strong growth would eventually raise inflationary pressures and responded with a faster pace of tightening in order to avoid falling behind the curve and secure its inflation-fighting credibility. Exhibit 2 shows real-time economic data at the time of these meetings.
Here are Goldman's thought on the rate hike acceleration triggers:
At the end of the 1999-2000 hiking cycle, the FOMC delivered a larger 50bp hike in May 2000. Core inflation was around 2%, but growth was extremely strong and participants were concerned about a dip in the unemployment rate to 3.9%, a 30-year low, and an acceleration in wage growth that former Chairman Greenspan considered “unambiguous” and Governor Meyer saw as a clear inflection point.
As Goldman's economists conclude, the Fed was sufficiently worried about inflation to not only tighten somewhat preemptively, but to accelerate the pace of tightening. In this context, "Powell’s comment suggests that today the FOMC would need to see more of a realized inflation overshoot too—roughly a core PCE reading above 2.5%, in our view—but history suggests that concerns about the eventual consequences of persistently strong growth momentum or high wage growth could tip the scales in a close call."
Pausing the hiking cycle
The far more realistic option for the Fed, especially if full-blown trade war with China breaks out and hit global growth (even if it means higher inflation) is for the Fed to pause the rate hike cycle. The mid-cycle pauses in 1994-1995 reflected a different approach to tightening in which the FOMC used large moves to catch up quickly and demonstrate its commitment to fighting inflation, then skipped a meeting to gradually assess the impact.
At the time the Committee feared, as New York Fed President McDonough put it, that 25bp hikes might be misperceived as indicating “timidity” or a compromise. These pauses have less relevance today, as does the December 1999 pause motivated by Y2K fears. More interesting today is the October 1999 pause, when the FOMC was split on whether to hike. Although the unemployment rate was 1pp below the Committee’s estimate of the sustainable rate or NAIRU, Greenspan led a slight majority for a pause by arguing that rising productivity growth might prove to be a lasting feature of the new high-tech economy that would dampen inflationary pressures. In his view, a major breakout of inflation was a “non-credible prospect at this point.”
Ending the hiking cycle
The final option, and the one which the market until recently was pricing in for late 2019/early 2020, was that the Fed would finally end the rate hike cycle as it surpassed its (inaccurate) estimate of the neutral rate. How has the Fed passed this threshold in the past?
As Goldman notes, an interesting quirk emerges when looking at the historical record at the meetings where the FOMC concluded these three hiking cycles by taking no action which - at least initially - were little different from a pause. Specifically, in most cases, the Committee did not necessarily think it was done hiking. In 1995, the Fed made its usual 50bp hike in February followed by the usual pause in March, but then held off in May as well. The key reason was that the unemployment rate had risen 0.4pp to 5.8%, close to the Fed’s structural rate estimate, that growth had slowed meaningfully, and that the policy stance was already well into restrictive territory in the views of most participants. In fact, within a couple of months of the end, that “extra braking action” was seen as unnecessary and the Committee retreated to a “more neutral stance,” as then-Fed governor Yellen put it.
Fast forward to the time of the dot com bubble, when in June 2000 the unemployment rate was still more than 1pp below the staff estimate of NAIRU. Why stop there? There were several reasons: doubts about whether estimates of NAIRU should be a guidepost for policy; strong productivity growth kept inflation contained; and most importantly, as the Committee noted in its statement, demand growth seemed to be moderating toward roughly the economy’s potential, meaning that at least the labor market overshoot wouldn’t grow further. With a policy rate already above neutral at 6.5%, that was good enough.
The most famous ending of the rate hike cycle took place in August 2006 when the 2004-2006 cycle ended after 17 consecutive 25bp hikes in a contentious decision. At the time, core inflation remained about ½pp above target and the labor market was slightly overheated. But the FOMC held off because it by then expected weakness in the housing sector to spill over to a broader slowdown in consumption, leading to a rising unemployment rate in staff projections. At the time, the funds rate was in the middle of staff estimates of the neutral rate. Also of note: the yield curve had inverted and the economy was about to enter the biggest financial crisis since the Great Dperssion.
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From these observations, Goldman draws the following three lessons.
- First, accelerating the pace of tightening would likely require a meaningful inflation overshoot, though history suggests that a large pick-up in wage growth would strengthen the case.
- Second, a mid-cycle pause during an ongoing labor market overshoot occurred only in the context of a historic productivity boom that reduced inflation concerns, a condition we are far from today.
- Third, past hiking cycles ended either with growth near potential and an already-restrictive policy stance or with growth already below potential and a roughly neutral stance, in either case reassuring the FOMC that the labor market overshoots at the time wouldn’t grow further.
For its part, Goldman - which has been bullish on the US economy, accusations by Trump that it is a Democratic operative notwithstanding - continues to expect five more rate hikes through the end of 2019, "with risks tilted to the upside." Furthermore, the guidance from Chairman Powell and the historical lessons noted above suggests that upside risk could take the form of either a faster pace of hiking if inflation surprises to the upside, or a longer hiking cycle if growth remains stronger than expected in 2020, especially since that would be inconsistent with the gradual reversal of the labor market overshoot shown in the FOMC’s latest Economic Projections.
That said, no matter what the future of the rate hiking cycle brings, it is worth reminding readers of the following chart...
... which shows that every single tightening cycle ends with a financial crisis, as Deutsche Bank's Alan Ruskin explained back in May:
- Every Fed tightening cycle creates a meaningful crisis somewhere, often external but usually with some domestic (US) fall out. Fed tightening can be likened to the monetary authorities shaking a tree with some overripe fruit. It is usually not totally obvious what will fall out, but that there is ‘fall out’ should be no surprise.
- Going back in history, the 2004-6 Fed tightening looked benign but the US housing collapse set off contagion and a near collapse of the global financial system dwarfing all post-war crises.
- The late 1990s Fed stop start tightening included the Asia crisis, LTCM and Russia collapse, and when tightening resumed, the pop of the equity bubble.
- The early 1993-4 tightening phase included bond market turmoil and the Mexican crisis.
- The late 1980s tightening ushered along the S&L crisis.
- Greenspan’s first fumbled tightening in 1987 helped trigger Black Monday, before the Fed eased and ‘the Greenspan put’ took off in earnest.
- The early 80s included the LDC/Latam debt crisis and Conti Illinois collapse.
And a post-script from Ruskin's colleague at DB, Jim Reid:
A reminder that our note from last September suggested that financial crises have been a very regular feature of the post-Bretton Woods system (1971-) and that based on history we’d be stunned if we didn’t have another one in some form or another by around the end of this decade/turn of the next one.
The most likely catalyst was the “great unwind” of loose monetary policy/QE around the world at a time of still record debt levels.
We would stand by this and I suppose the newsflow and events this year so far makes me more confident of this even if we’re still unsure on the timing or the epicentre.
So for all those curious when the next crisis will finally strike, just ask the Fed, because every prior crash was manufactured by the Federal Reserve. This time won't be different.