The “High-Pressure Economy” experiment has begun

15 Oct 2018

Key points

  • The recent repricing of expectations for monetary policy has once again caused a wobble in risk assets. But the move higher in real Treasury yields may reflect greater investor confidence in the medium-term growth outlook.
  • Indications that the new Federal Reserve leadership remains unconvinced that monetary policy will need to turn restrictive may be underpinning this confidence in the outlook. With inflation expectations well-anchored, the core of the FOMC appears comfortable running a “high-pressured economy” that provides incentives for stronger business investment, which could ultimately boost trend growth and relieve inflationary pressures.
  • As markets are now closer to fully discounting the terminal policy rate for this cycle, the environment favors carry in many fixed income markets. We feel particularly comfortable owning risk assets at the front of the curve.

We have been fairly consistent in previous quarters in our view that there are many reasons to be concerned about the macro outlook. This quarter, and despite recent equity market developments, we take a pause from our doom and gloom and pay tribute to a truly remarkable economic run that appears poised to become the longest in history. First, some background. The ability of the United States economy to weather higher interest rates remains one of the enduring questions of an expansion that is entering its tenth year. Over recent years, investors have periodically fretted that continued monetary policy tightening will eventually throw the economy into a recession. To some, risks of a monetary policy error have been heightened by the fact that inflationary pressures have remained muted, as well as the belief that cyclical and structural factors have suppressed the neutral policy rate.

Recent developments have put this narrative to the test. Markets are currently pricing a higher terminal policy rate for this cycle than at any other point in time since the FOMC began raising rates in 2015, while consensus forecasts are for growth to remain solidly above trend at least through the end of next year. However, similar to the spring, the recent discounting of higher policy rates has contributed to a decline in equity prices. As we write this update, the S&P 500 index has fallen about six percent from its September peak as the 10yr US Treasury yield jumped as much as 25 basis points.

We caution against over-interpreting the recent declines in US equity indices as signifying new and significant concerns about the US outlook. The higher interest rates that initially prompted equity market losses might reflect a growing view that trend growth will pick up in the years ahead, and that recession risks will remain contained under new Federal Reserve leadership that continues to signal that any move of monetary policy to restrictive territory will likely be modest. As for trend growth prospects, there are already some encouraging signs in the productivity data. In addition, strong investment spending in recent quarters, should it continue over the medium term, suggests even better days ahead for productivity growth.

One remarkable feature of this possible shift in investor perceptions of the growth outlook is that it has not been accompanied by a change in views at the central bank. With some minor variations along the way, Federal Reserve policymakers’ outlook of growth decelerating to trend against a shallow path of rising policy rates has not shifted materially over the course of this year. And the new leadership has downplayed the need to take policy into restrictive territory, which may be buoying investors’ confidence in the durability of the expansion. Indeed, the FOMC’s most recent projections make clear that the Committee is engaging in a strategy aimed at prolonging the expansion indefinitely, at the risk of above-objective inflation. In practice, Chairman Powell seems comfortable running an experiment that his predecessor hinted at only in theory, namely, running a “high-pressure economy” in an attempt to boost investment spending and trend growth. Amidst the sell-off, there may be signs that bond market investors are validating the experiment – as of writing, the real 10-year Treasury yield recently reached its highest level since early 2011, but the market-based measure of 10-year inflation compensation still remains close to its expansion average.

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