Is the Fed Inviting Recession?

After the Fed’s December monetary policy meeting closed yesterday, one question seems to be haunting media: Is the Fed on course to err, tightening policy amid a weakening economy and potentially inviting yield-curve inversion and recession? In our view, no. While the narrower yield spread increases the risk of an error, we think the worries mistake communications for forecasts and overstate the risk of a yield-curve inversion today. 

Yesterday, the Fed raised its fed-funds rate target range by 0.25 percentage point (to 2.25% – 2.50%), the fourth hike this year and ninth since December 2015. Additionally, the Fed released its “dot plot”—a communication sharing Federal Open Market Committee members’ estimates of future rates, which many claim now suggests two hikes next year, down from three. Finally, at the presser, Chair Jerome Powell noted the bank would continue its policy of letting $50 billion in bonds it bought under quantitative easing (QE) mature monthly. While all these moves were widely expected, markets seemed spooked in the aftermath, with the S&P 500 reversing earlier gains and falling -1.5% on the day.^[i] Many attributed this to apparent signs the Fed believes the economy is weakening—yet is proceeding with tighter monetary policy anyway.

However, we think a closer look at the actual policy measures and communications discussed may help assuage fears. Yes, two 0.25 percentage point hikes next year would push the upper end of the fed funds target range (2.50%) past the present 10-year Treasury yield (2.77%), inverting the yield curve.^[ii] And yes, it is true that, historically, inversion indicates credit markets are troubled and a recession may be on the way.^[iii] But presuming an inverted yield curve looms seems premature to us.

Contrary to common chatter, the dot plot isn’t a rate-hike plan. It isn’t even a forecast! It shows Fed members’ predictions for the effective fed-funds rate at the end of the next three calendar years, plus a “longer run” level. Each Fed member dots his or her own plot. These plots are then aggregated into a single chart—the latest version of which looks like this. Media typically treat the median dots—the ones smack in the middle of members’ forecasts for each year—as planned hikes. In theory, if the median Fed member believes fed funds will end the following year half a percentage point above its current level, that signals they plan two 0.25 percentage point hikes next year.^[iv]

But the plot from Wednesday’s meeting shows six Fedsters predicted rates 0.75 percentage point higher than current levels (so, three hikes), five predicted 0.50 percentage point, four predicted 0.25 percentage point and two no change. The median was 0.50. But if everyone voted according to their forecast (a huge stretch—more on this below), the three-hikers would still have a majority. So treating the new dot plot’s median as an ironclad prediction of two hikes next year is a fallacy, in our view.

Even if all Fed members forecast the same number of hikes, they still wouldn’t be set in stone. A member’s estimates of future fed funds levels don’t represent a plan to vote a certain way, much less a commitment. They are projections of what each member thinks the appropriate monetary response might be if the forecasted economic conditions come to pass. But economic data change, as do committee members’ interpretations thereof. They are humans, after all. And despite recent talk of a supposed “new era” under Jerome Powell in which uncertainty about the economy’s path forces the Fed to react meeting-by-meeting to the latest economic stats, Fed heads have long stressed that their decisions are “data dependent”—based on the latest information and data.

This data dependence means the Fed is constantly updating its view of appropriate monetary policy as new facts emerge or members’ opinions change. For example, after raising rates seven times from February 1994 – February 1995, Alan Greenspan’s Fed reversed course and cut rates three times. It then stood pat until a single hike in 1997, which preceded three more 1998 cuts. We aren’t forecasting cuts, a hold or hikes—again, Fed moves aren’t predictable—but a pause or reversal of the present hiking trend wouldn’t be unheard of. There is already some evidence the Fed is monitoring the yield curve—evidence in the form of special questions asked in the Fed’s October Senior Loan Officer Survey regarding the impact of this year’s flattening and a hypothetical 10-year minus 3-month inversion. They may or may not act on the information, but it suggests at least someone at the Fed is thinking about this issue.

Then again, even two hikes next year wouldn’t be actionable for investors, in our view. Yield curve inversion depends on where long rates go. These are a function of supply and demand, not Fed action. Down is one possibility—but so is up. And this is where worries over the Fed continuing to allow its QE-bloated balance sheet to shrink look strange. For one, the Fed’s sticking to its planned unwind merely reiterates a 15-month-old policy which, in our view, efficient bond and stock markets long ago pre-priced. But even in the unlikely event they haven’t, the Fed’s unwind means less pressure on long rates—it would in theory steepen the yield curve, mitigating rising short rates’ flattening.

Now, one thing is apparent to us about the narrower yield spread: It has increased the risk of a monetary policy error. However, given there hasn’t been inversion, we don’t think they have made one yet. Further, inversion tends to impact stocks and the economy at a significant lag, making it a poor timing tool. Reacting early could mean missing out on a big chunk of bull market. Hence, we see little reason to speculate today about when or if it may arrive.