Chatter this morning, reported by MNI’s well-placed anonymous sources within The Fed, suggests The Fed may end its rate-hike cycle as soon as this coming spring (which ironically is pretty-much what the market also believes judging from money-markets).
However, while leaks like this are extremely unusual (even for a divided Fed struggling with being the ‘one’ to bring the third mega-bubble down in two decades), Goldman Sachs latest note suggests those hoping that tumbling asset values in stocks and corporate bonds will be enough to stop The Fed in its tracks… will be deeply disappointed.
Via Goldman Sachs,
How Does Fed Policy React To Stock Market Declines?
The equity market sell-off since the beginning of October has led to questions around whether the Fed will maintain its current path of rate hikes. Historically, the Fed appears to have responded with more accommodative policy after stock market sell-offs, on average (Exhibit 1). This has led some to conclude that there is a Fed “put,” in which the Fed responds to large stock market declines with accommodative policy, but does not change course when faced with small declines or increases in stock prices.
Exhibit 1: Historically, Sell-Offs in Stocks Have Preceded More Accommodative Fed Policy
Source: Federal Reserve Board, S&P, Haver Analytics, Goldman Sachs Global Investment Research
The Fed might react to stock market sell-offs for two reasons. First, stock price declines can serve as a financial market signal of lower growth in the future. Second, stock price declines and FCI tightening can cause a drag on future growth, for instance through wealth effects on consumer spending.
We find that stock market sell-offs are more likely to worry the Fed if they occur in tandem with a broader tightening of financial conditions or in an environment of weak growth. Looking at the sample of FOMC meetings that follow stock market sell-offs, we find that the Fed is more likely to decrease the fed funds rate when credit spreads are widening simultaneously (Exhibit 2, left). We also find that the Fed is more accommodative when current growth is weak relative to potential (Exhibit 2, right). Such cases of stock market sell-offs correspond to times of elevated recession risk, suggesting the possibility that the Fed responds more aggressively to address downside risks. Today, in contrast, credit spreads have widened only moderately, and growth remains significantly above potential, with limited recession risk over the next year.
Exhibit 2: The Fed Only Responds to Stock Market Sell-Offs That Happen At the Same Time as Widening Credit Spreads or Growth Significantly Below Potential
Source: Federal Reserve Board, Congressional Budget Office, S&P, Haver Analytics, Goldman Sachs Global Investment Research
In fact, the Fed responds to stock market declines differently depending on whether the economy is currently in recession or not. Exhibit 3 shows that most cuts in the fed funds rate after stock market declines occurred in recessions or the immediate recovery after a recession.
Exhibit 3: Fed Policy Is Less Accommodating After Stock Market Sell-Offs in Non-Recession Periods
Source: Federal Reserve Board, S&P, Goldman Sachs Global Investment Research
We next look at specific historical examples of the Fed’s policy response to equity market sell-offs outside of recessions to help understand how the Fed might react today in a non-recession environment.
The current environment most closely resembles two instances in which the Fed continued rate increases amidst a broader hiking cycle.
In May 1994, the Fed hiked 75bp despite a 6% stock market decline in the prior months, and in August 2004, the Fed continued with a 25bp hike. In both cases, the pace of growth was over 1.5pp above potential and credit spreads did not widen significantly, and the Fed continued to hike in order to slow growth.
The Fed did respond in a dovish way to an equity market sell-off in two notable instances. In September 1998, the Fed cut the policy rate by 25bp, and in early 2016, the Fed held off on further rate hikes. In both cases, growth was below potential. The 1998 cut came alongside a broader financial panic, and late 2015 and early 2016 also saw a significant widening of credit spreads and a significant worry about recession. This left little room for the Fed to tolerate a large decline in the stock market and a corresponding tightening of financial conditions.
Taken together, the evidence from these historical examples and our empirical analysis suggest large differences in the Fed’s response to stock market declines, depending on broader financial conditions as well as growth. With other financial conditions such as credit spreads still at moderate levels, and with growth running well above potential, the Fed is likely to continue with their current pace of tightening despite the decline in equity markets.
This supports our view that the Fed will hike in December, with a subjective probability of 90%. Beyond this, we expect four hikes in 2019 to a terminal funds rate of 3¼-3½%, with risks that are broadly balanced.
Goldman’s projections are extremely hawkish (especially compared to the market – see first chart above), and an increasing number of analysts still believe The Fed will pause next year:
“I wouldn’t be surprised if the Fed backs away from the three hikes it has built into 2019,’’ said Donald Ellenberger, a senior portfolio manager at Federated Investors Inc.
“The debate right now isn’t whether they go in December,” Bank of America’s Harris said. “It’s about when do they pause next year. That’s going to be increasingly data dependent and it’s going to be a game-day decision to some degree as we go into next year.”
“December is probably too early for pause, but we could certainly see it in the first half of next year,’’ said Gene Tannuzzo, fund manager and deputy global head of fixed income at Columbia Threadneedle Investments. “Markets need to adjust to lower and slower, both in terms of growth and interest-rate increases.”
So, whether MNI’s report was a well-placed hype note to squeeze stocks higher ahead of Black Friday is unclear, but for now, The Fed seems heart-set on popping bubbles and normalizing rates and balance sheets (remember how many times the asset-gatherers told us that the market is not the economy?).
Indeed, as Bloomberg notes, comparing today’s conditions with the end of 2015 when the Fed raised rates for the first time in this cycle, credit spreads are a lot tighter now; and ISM manufacturing is around 58, as opposed to sub-50 three years ago…
Simply put, while this drop has felt painful for those in the most momo of momo stocks, financial and economic conditions have to worsen much further for the Fed to have a change of heart.
Additionally, as Bloomberg reports, any scaling back in the Fed’s rate projections would face complications. President Donald Trump has vociferously and repeatedly criticized the Fed’s rate increases. “We have much more of a Fed problem than we do with anyone else,’’ he told reporters in Washington on Tuesday.
The last thing that Powell and his colleagues probably want is to be seen as caving in to the president’s demands.That would undermine the central bank’s credibility and could cripple its ability to steer the economy.
The Fed also likely wants to avoid being seen as rushing to the rescue of the beleaguered stock market. Powell said last week that equity price moves were only one of many factors that the Fed takes into account in setting policy.
Finally, we note that if The Fed wants to start changing tack from its hawkish trajectory, then next week offers a number of opportunities:
- Nov. 27: Clarida speaks in New York
- Nov. 28: Powell speaks at Economic Club of NY
- Nov. 29: Minutes of last meeting released
- Nov. 30: Williams speaks on the global economy at G-30 meeting
- And then on December 5, Powell goes before the Joint Economic Committee in Congress.
“If there’s ever a time to signal a change in the 2019 rate path, this is a prime opportunity,” writes Societe Generale economist Omair Sharif, who takes a dim view of the idea that the Fed will slow the pace of rate hikes. The Fed has shown no qualms about jawboning the markets to get back in line with its hawkish path, and so the next two weeks could be all about removing the dovish pricing that’s recently coursed through the markets.