United States

Ready the bullpen: Business cycle enters late stages

Fed weighs policy options ahead of next downturn

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The business cycle is clearly closer to its end than beginning. To use a baseball analogy, the starting pitcher is about to leave the mound and it’s time to get the bullpen warmed up. In other words, the middle market should begin to consider what the end of the business cycle will look like and what that means for future growth. The post-economic expansion phase of the current cycle is clearly on the minds of policymakers and has been a topic of conversation in several of the most recent Federal Reserve meetings.

Since 1945, the Fed has relied on about 400 basis points of firepower accompanied by a significant boost from fiscal policymakers to stimulate the economy. However, the current economic expansion has been like no other. With the Fed’s benchmark policy rate floating between 1.5 and 1.75 percent, and a late-cycle fiscal boost of $1.5 trillion following passage of the 2018 $1.3 trillion budget, policymakers’ capacity to act forcefully in the face of a recession is far more constrained than usual.

When the business cycle does end, the onus on fighting the recession will fall squarely on the shoulders of the central bank. With the policy rate well below what has been considered normal at this point of the business cycle, the Fed will likely be forced to resort to another series of unorthodox policies to help the economy recover, especially if the downturn is deeper or runs longer than expected.

The U.S. budget deficit as a percentage of nominal gross domestic product (GDP) the onset of the past six recessions (1973-2001) has averaged 1.8 percent. Based on RSM projections, if the United States were to hypothetically enter a recession sometime around 2020-2021, the budget deficit-to-GDP at ratio would stand at a minimum of 5.1 percent, with considerable risk of a much deeper deficit. This will leave fiscal policymakers a very narrow margin to plug the hole in private sector activity without putting severe upward pressure on interest rates.

Given the trajectory of the U.S. fiscal imbalance due to a combination of sluggish growth and increasing fiscal and trade deficits, it is difficult to conceive of a situation where an attempt by the U.S. Treasury to mitigate an economic downturn through fiscal policy wouldn’t trigger an increase in the risk premium (i.e. higher interest rates) demanded by domestic and foreign purchasers of Treasury notes along the entire maturity spectrum. Although we do believe the fiscal authority will act, it is highly doubtful (given the late-cycle fiscal boost put in place over the past year) that it will be anything other than a modest complement to the steps the Federal Reserve will be forced to take, especially if the downturn is more than the garden-variety average nine-month recession. The 2007-2009 Great Recession, the worst economic crisis since the Great Depression, was the exception rather than the rule among postwar economic downturns.

MIDDLE MARKET INSIGHT: While it is understandable that many middle market businesses may at first glance read this as a significant deviation away from the type of monetary policy that characterized the period of 1985-2005, it’s critical that forward-looking business managers consider the impact of possible policy options.

Consequently, the Fed will be left with the job of mitigating a downturn through a combination of lower real rates, which will likely again veer into deep negative terrain, and a series of unorthodox monetary policy steps that will again attempt to suppress long-term interest rates to increase accommodations, as the central bank implements policy along the nominal zero boundary of interest rates.

In the 12 recessions since 1945, the Fed has cut interest rates by an average of 400 basis points. However, in the most recent six recessions since 1973, those cuts have increased to an average of about 527 basis points. This suggests that even if the Fed hits its target by the middle of 2020 (based on the current summary of economic projections of 325 to 350 basis points in policy maneuverability), it will have firepower well below what it has had access to during the past six recessions.

This means that in the next recession the Fed will likely do two things: First, it will aggressively cut the nominal rate and reach the zero boundary of interest rates quite quickly, likely within one year of the start of its accommodation campaign.

Second, given the experience of forward guidance, the phrase describing explicit qualitative communication strategy the Fed used during the Great Recession to explain the expected future path of its main policy rate, the central bank would likely utilize both the “dot plots” inside the quarterly summary of economic projections and the monthly policy communique to signal the commitment that rates will remain lower for longer than implied by estimates of the central bank’s reaction function. This would have the effect of compelling market participants to bid down long-term yields. That, in turn, would provide increased accommodations, even as the policy rate bumps against the zero boundary. In our estimation, the greater the time-dependent forward-looking guidance the policy communication is (for example, lower rates for one or two years), the greater the probability that policymakers will likely push rates lower, creating conditions for the resumption of economic growth.

‘Quantitative easing’ unlikely to be a Fed tactic

Unlike during the Great Recession, the Fed will probably refrain from large-scale asset purchases, or what is referred to as quantitative easing. Only if the economy were to suffer a severe shock would the central bank resort to this policy tool to lower interest rates and increase the money supply.

While we can make a strong case that central bank purchases of open market securities financed by the creation of bank reserves held at the central bank were decisive in putting a floor under the Great Recession (and resulted in a relatively stronger recovery than would otherwise have been the case), quantitative easing is a policy tool unlikely to be used outside of an unforeseen economic shock. And even then, such a tactic would face significant opposition in Washington D.C., which remains deeply divided on party lines.

So this raises a question: If the next downturn proves more difficult than expected, what alternatives could the central bank turn to? Some suggest the United States could lift the inflation target (2 percent), turn to negative interest rates as the European Central Bank and the Bank of Japan (BOJ) have done, or target the yield curve as the BOJ has done. In our estimation, lifting the inflation target would place transition costs on the public in a way that would likely reduce the Fed’s hard-earned credibility, prove confusing to the public and investors alike, and be very difficult to manage if inflation expectations become unanchored.

Turning to negative interest rate policy would likely yield a major backlash from Washington D.C. policymakers and currently has little support inside the Fed. While targeting of the yield curve is a popular academic discussion, there is significant doubt about its practical implementation in the United States.

Recently, former Federal Reserve President Ben Bernanke recommended that the central bank consider yet another alternative, a temporary price level target analogous to what the Fed, in recent statements, refers to as its “symmetrical inflation policy objective.” What this means is that, as the central bank attempts to keep the long-run average of 2 percent near its inflation target, it will accept a temporary deviation from that target during economic downturns and recoveries. But this could result in long-term inflation expectations becoming unanchored. Or, to paraphrase Bernanke, a price level targeting regime would commit to reversing temporary deviations of inflation from the target by following a temporary surge in inflation with a period of inflation below target, then following an episode of lower inflation with a period of inflation above target.

In our estimation, the Fed’s recent use of the phrases of “symmetric 2 percent objective over the medium term” and “the committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal” in its May policy statement means the Federal Open Market Committee is clearly signaling to market participants that it intends to tolerate temporary deviation away from its inflation target in the near-term. More importantly, the Fed is providing a road map for those who are serious about monetary policy and the probable policy options ahead of the next recession.

While it is understandable that many middle market businesses may, at first glance, read this as a significant deviation away from the type of monetary policy that characterized the period of 1985-2005, it’s critical that forward-looking businesses consider the impact of possible policy options that both the fiscal and monetary authorities will consider well ahead of any downturn.

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