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Will The Fed Flip-Flop On Interest Rate Hikes? Recession Debate Continues

The Fed just started hiking interest rates late last year, but Mr. Market didn’t think regulators would go through with the four rate hikes they initially planned for this year. Now economists are debating how many interest rate hikes we can expect this year and whether the Fed will reverse course and go back to easing monetary policy and it is all part of the Recession Debate .

 

Recession Debate Recession Debate Recession Debate Recession Debate Recession Debate  – Interest rate policy up in the air as markets “in a foul mood”

Bank of America Merrill Lynch Global Economist Ethan Harris said this week that he’s estimating a 2% growth rate in gross domestic product for this year, a reduction from his previous estimate because, as he says, the markets are “in such a foul mood.” He’s also expecting the unemployment rate to keep dropping and wages and core price inflation to pick up—all of which would be excellent indicators of an economy in recovery mode.

However, he’s also not expecting another interest rate hike until June, highlighting that in spite of the expectations for economic improvements coming this year, the U.S. economy remains very fragile. He also doesn’t think the Fed will do another rate hike until December, meaning his expectations for interest rate hikes has now been cut in half from four to two.

50/50 chance of recession priced in

Economists have been trying to calm investor fears about a recession, and they appear to have succeeded somewhat, particularly as this week has brought a nice rally across the board. However, Harris still thinks the stock market is pricing in about a 50% probability that we see a recession in the next 12 months.

He echoes the sentiments of most other economists in saying that market fear is now trumping fundamentals as most of the recent economic data points have been positive. He thinks a recession will only happen if two stipulations are met. One is a significant worsening in the risk-off trade, and the other is the Fed utterly failing in in trying to offset the shock that’s roaring through the markets.

He adds that a slowdown in growth is certainly possible, but he pegs the probability of a recession in the next 12 months at only 25%.

Recession Debate  – Will the Fed reverse course?

Interestingly, he places a 40% probability on the Fed either halting interest rate hikes or just reversing course before the end of the year. However, he thinks this will only happen if some major signals that the economy is under serious financial stress pop up or if it looks like growth is falling below where it could potentially be.

Harris also argued that investors are too worried that the Fed is just “running out of ammunition.” After all, policymakers have plenty of tools they can use, as he calls them “the Fed-funds equivalent of between 150 and 200bp of easing in its arsenal.” He thinks this range provides plenty of wiggle room to manage either a slowdown or “moderate financial shock.”

Recession Debate  –  Fed is being “cagey”

Following this week’s meeting of the Federal Open Market Committee, well-respected economist Dave Rosenberg picked up on the high level of uncertainty policymakers have regarding the economy right now. The word “uncertainty” or a derivative of it appeared many more times in the January meeting notes than it has over the last several years.

Harris picked up on this very same thing, although he described it as the Fed being “rather cagey about how they would respond to a serious weakening of the economy or financial conditions.” He sees two possibilities for how policymakers might handle this. One is that they might use some measures to improve the market’s function, although the Dodd-Frank Act has placed constraints on what they could do in this case. For example, they can’t do anything that would help absorb credit risk, although he suggests that they might pick up some liquidity tools in the event that the market begins functioning erratically.

Recession Debate  – Negative rates not totally out of the question

The other possible course of action involves stimulating the economy by introducing macro policies to help reverse a meltdown. Harris said this could involve easing some of the newer regulatory rules that have weighed on the bond market’s liquidity. He sees a certain sequence of events if policymakers decide to go the macro route, the first step of which they have already taken, which is providing “soft guidance,” which he describes as “underscoring data dependence and hinting that they are unlikely to hike in a turbulent environment.”

He says the second step would be holding while giving “a more forceful statement of policy options,” while the third is slashing interest rates almost to zero and issuing strong guidance. He sees this third step as happening if the market drops into a “full bear market.”

The fourth step he describes as “operation twist two,” which he equates to being similar to the 2012 Maturity Extension Program. The Fed currently has $408 billion in assets that will mature over the next two years, so it could reinvest those assets on the long side or sell short-dated assets ahead of their maturation date.

If none of the above steps have worked, Harris says the Fed could start a fourth round of quantitative easing by buying Treasuries of at least $40 billion per month, which was the pace of the third round of QE. He also says the Fed could buy some agency-based debt and mortgage-backed securities in the event the housing market wobbles.

And finally we have the last-ditch effort of adopting negative interest rates, although he says this might be delayed or scrapped entirely if banks come under “serious stress.” Swedish policymakers adopted this strategy, and some are saying that it’s actually working even though it sounds crazy.

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