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Can we avoid a hard landing in the United States?

08 April 2022

Likely yes. The Fed has the models and tools to cool down the US economy. The prospect of recession as suggested by an inversion of the US Treasury curve are therefore somewhat exaggerated.

How to deflate a hot air balloon

The Federal Reserve knows that real interest rates need to be positive for monetary policy to be tight, but this doesn’t tell you when to stop raising interest rates. The Fed addressed this point last week as a discussion on the equilibrium interest rate known as R*, whose value it agrees is uncertain. It can be derived by:

  1.  Complex dynamic macroeconomic models (e.g. Gerali and Neri (2017) and Haavio et al (2017)). They estimate the dynamics of interest rates including the equilibrium, or R*, when there are no shocks to the economy and it runs at trend.
  2.  R* can also be derived by making assumptions about the supply and demand of capital in the long-run and degree of technology and demographic forces among other factors. Two typical models to determine R* in this way are Laubach-Williams (2003) and Holston-Laubach-Williams (2017).
  3.  The Fed can estimate what a series of rate hikes would do to cool down the economy in abnormal circumstances, known as a Quantile impulse function. Advanced models like this ask the question, how would the economy respond if there was a fire spreading to the labor market?

The problem is that these models can learn only from the experience of the early 1980s when inflation was surging very rapidly. Will the models learn enough from the early 80s and will they learn the right lesson? They should do a decent but imperfect job because of differences between now and then. The main differences between the 1980s and now are that the labor movement was far better organized then, manufacturing much larger, and that the Fed had not conducted an enormous expansion in its balance sheet over many years to arrive at 37.9% of GDP. Another difference is that the wealthy have become vastly more wealthy since 2008.

The path of interest rates is not the only concern: the Fed estimates that the balance sheet reduction this year will be the equivalent of an additional 0.25% rate hike. Given the number of channels through which quantitative tightening impacts the economy, this represents another means of slowing the economy whose impact is hard to forecast, especially its impact on an expensive stock market. The Fed will start in May reducing its balance sheet by 95 billion a month, a very rapid pace.

What does it mean?

While the Fed has lost credibility running after a more hawkish market, it has the tools to do the job and should eventually take back control of the narrative by sending strong signals such as the rapid reduction in the Fed’s balance sheet. Hence, the opportunity set in US fixed income remains therefore large.

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