- Monetary policy action can take up to two years to fully work through the economy, meaning much of the impact of previous rate hikes is yet to come.
- Soft landings are rare in Fed history; policy makers more typically overdo it because of the long lags between interest rate hikes and their impact on the economy. This cycle is complicated by several shocks outside of the Fed’s control.
- While the US economy has shown resilience so far this year, current economic conditions suggest economic momentum is decelerating.
- Rain portfolios are well prepared to weather a mild recession next year with an emphasis on the income and safety of bonds and Low Correlation Growth strategies to buffer equity volatility.
The surprising resilience of the US economy in the face of sharp interest rates hikes over the past 18 months has sparked enthusiasm in markets for a soft landing. Economic growth has been surprisingly strong this year and inflation pressures appear to be easing, giving the impression that the Fed may have engineered a pathway out of high inflation that won’t trigger a full-blown recession. And while Fed Chairman Powell has echoed this enthusiasm, saying “there is a path to a soft landing,” incoming data and history suggest otherwise. In fact, a look at key sectors of the economy tells us that economic momentum is slowing while a look at the Fed’s record of managing economic cycles tells us that soft landings are extremely rare.
Soft landings are hard to achieve primarily because of what economist Milton Friedman called the “long and variable lags” between monetary policy actions and their effects on the economy. Even when the Fed does have an accurate estimate of how much it must raise rates to slow economic growth to a desired level, how quickly the economy responds is difficult, if not impossible, to predict. When the Fed raises its benchmark fed funds rate, other interest rates across the economy move as well, though not necessarily instantly or by the same magnitude. In response, companies and households adjust their borrowing and spending to account for the higher interest rates. They factor in their own expectations of how the economy will evolve and what they think inflation and real interest rates will do in the future. As these decisions ripple through the economy, they have multiplier effects that magnify or diminish the initial interest rate action. From start to finish, the overall process of changing the fed funds rate to seeing its full effect on something like GDP can take anywhere from one to two years.
These long and variable lags almost invariably lead policymakers to overshoot; after seeing little or no immediate effects on inflation (and with markets and politicians clamoring for quick action), they often keep raising interest rates well beyond what is needed to control inflation, typically causing a recession (the hard landing). This reality prompted economist Rudi Dornbusch to observe that “No postwar recovery has died in bed of old age – the Federal Reserve has murdered every one of them.” He’s not far off. In fact, the Fed has pulled off only one soft landing in its history with the tightening cycle that began in 1994 under Fed Chairman Alan Greenspan.
To complicate things further, the Fed can only impact the demand side of the economy. Supply shocks like the oil and food price hikes caused by the Russian invasion of Ukraine can interrupt the Fed’s trajectory and force a course correction in mid-stream. Historically, these shocks come in many forms: an oil price shock in the 1970s, the fiscal shock of Vietnam War spending, Reagan’s tax cuts, Carter’s credit controls and so on. Most recently, the massive $7.2 trillion fiscal shock of COVID crisis spending, coupled with supply chain disruptions and the aforementioned oil and food price hikes are among the most complex supply side shocks the Fed has ever had to respond to. In other words, there are a lot of non-monetary banana peels to slip on this cycle.
Not surprisingly, the Fed’s ability to finesse a soft landing also depends on how high inflation is to begin with. When Greenspan orchestrated his perfect landing in 1995, he was not fighting high inflation at all. Rather, the Fed was attempting to preempt what it perceived to be a potential rise in the inflation rate. When Chairman Paul Volcker tackled the double-digit inflation of the late 1970s, the ensuing recession was long and deep, one of the harder landings in Fed history. In the most recent cycle, the Fed is fighting high single-digit inflation and was self-admittedly late to the game when it started hiking rates in March 2022, having dismissed early inflation spikes as “transient.” Although the story is still playing out, this premise, along with the complexity of supply side shocks in recent years, does not bode well for a soft landing this time around.
This brings us to a quick look at current economic conditions, which suggest economic momentum is decelerating. While business spending has held up better than expected this year, much of it has been focused on paying workers as opposed to making large investments in equipment and structures. Going forward, increased caution among lenders and slowing corporate profits are likely to be a headwind to capital spending. Similarly, consumers have remained resilient so far this year, in large part because of a tight labor market and rising real wages. However, savings are diminishing, and households are taking on more debt to maintain their current lifestyles. Even though revolving credit relative to disposable income looks manageable, delinquencies are now rising. Headwinds to consumer spending include higher energy prices, the resumption of student loan payments and, of course, higher interest rates.
The labor market has held up well this cycle, rebounding from the nightmarish job losses at the inception of the COVID crisis. We are beginning to see this strength ease, however, with job gains trending lower since last year. Furthermore, the improving labor force participation rate that has been supportive of job growth so far, appears to be plateauing. Participation rates for adults aged 25 to 54 have fully recovered to pre-pandemic levels while aging demographics – baby boomers who have permanently left the workforce – continue to depress the participation rate for those 55 and older. Together with lower legal immigration, labor supply growth is not likely to improve much from here. Recent Conference Board surveys indicate that job seekers are having a harder time landing jobs while business surveys indicate that hiring plans for services and manufacturing as well as small businesses will be moderating in coming months. The unemployment rate nudged upward to 3.8% in August, from an average of 3.6% earlier this year. The good news in this story is that cooling labor markets have taken the wind out of wage growth, a primary contributor to inflation.
Global growth is also slowing with just a quarter of the world’s largest economies registering growth in services and manufacturing, a barometer of economic momentum. European growth has been stumbling from high energy prices and pessimism in manufacturing (in August, Eurozone manufacturing new orders registered a 33-month low, contracting at one of the fastest rates since the financial crisis), while China is attempting to reignite growth after lifting its zero-COVID policy, which suppressed consumer confidence, services spending, and business investment. India, a beneficiary of the reorientation of supply chains out of China, is one of the few bright spots in the global economic story at the moment.
We don’t know yet if the Fed has over done it with rate hikes this economic cycle. We do know, however, that it intends to hike one more time this year in the face of a decelerating economic picture. This is in spite of the fact that, given the long and variable lags of monetary policy, much of the impact of previous rate hikes is yet to come. Given the Fed’s historical tendencies and the emerging economic picture, we think a soft landing is an increasingly unlikely fantasy at this point.
Equities struggled in Q3 after a strong first half of the year as investors took heed of rising market valuations and the narrow breadth of this year’s rally. The S&P 500 is now trading above 18 times forward earnings (a few points above its 25 -year average), making valuations look stretched. Furthermore, the difference between valuations of the most expensive segments of the market and the cheapest is well above average levels after just a few stocks drove most of the market’s gains this year. This means that while some stocks look expensive many remain attractively valued. Bonds also languished during the quarter as interest rates marched higher.
We are preparing portfolios for a mild recession next year. Bonds are looking attractive for the first time in several years, both because of their high income potential and their ability to buffer market volatility. We continue to keep portfolios underweight interest rate risk relative to benchmarks but are inching closer to normal as the Fed approaches the point where it will likely pause its interest rate hikes given the enormous progress on inflation it has made. Inflation remains a wildcard, however, as it tends to be more volatile at higher levels so we are cautious not to extend too much risk here. On the Growth side of portfolios, we are leaning into Low Correlation Growth strategies that have the ability to buffer equity market volatility. Active strategies in this space can be useful as they allow managers to focus on less expensive parts of the market.