Powell preaches patience, but these economists predict recession

on Feb27
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Federal Reserve Chairman Jerome Powell told senators on Tuesday that the Fed won’t strangle the economy with higher interest rates, but some economists clearly don’t believe him. They seem to think the Fed will quickly run out of “patience” and throw the economy into recession sometime in the next two years.

Financial markets had already incorporated patience into their expectations for no change in the benchmark interest rate for the foreseeable future, even before the Fed had come around to their way of thinking.

Business economists aren’t buying it. The economic policy survey released by the National Association of Business Economists revealed that three-quarters of respondents expect a recession to begin by the end of 2021, with 42% penciling in a downturn in 2020.

Those same economists would no doubt tell you that expansions don’t die of old age. Something kills them. And that something is the Fed, which historically has ignored a reliable leading indicator of recession — an inverted yield curve — and continued to raise the benchmark rate even as long-term rates rolled over.

If the Fed sticks to its guns — and my bet is that the Fed is done raising rates for the cycle — and calls a halt to its rate-normalization campaign, why would economists anticipate a recession?

Didn’t the Fed make a sudden, and timely, about-face in January in response to an absence of inflationary pressure, newfound slack in the labor market, and global tailwinds-turned-headwinds, all of which were conveyed not by data but by a deep dive in the U.S. stock market?

“We don’t ask people to connect the dots, but the survey showed concern about trade policy, some concern about fiscal policy and deficits being bigger than are safe,” said economist Ken Simonson, who serves as NABE’s policy survey analyst.

“Even if the Fed is doing the right thing, there’s a lot they can’t counteract or prevent,” Simonson said.

Powell expressed those same concerns at his semiannual testimony to the Senate Banking Committee on Tuesday, outlining favorable domestic conditions but expressing caution about “crosscurrents and conflicting signals” emanating from financial-market volatility, tighter financial conditions, slowing growth in China and Europe, and potential “event risks” from trade negotiations, unresolved government policy issues, and a messy, no-deal Brexit.

While Powell stressed that the Fed was in “no rush to make a decision about policy,” the Fed is hardly a neutral bystander in the NABE economists’ forecast.

NABE

A majority of economists surveyed by the National Association for Business Economics think the federal funds rate will rise to at least 3% before the Fed starts cutting.

While a majority said that the current monetary policy stance is “about right,” most thought that this represented a pause in the tightening cycle, not an end. Almost 60% expect the funds rate to be higher at the end of 2020 than it is now. And 62% of respondents look for the upper end of the funds rate range to be 3% or higher before the Fed reverses course and begins to lower rates.

In other words, business economists expect that, once again, the Fed will overdo its rate hikes with predictable results.

While there is still a minority of Fed officials who expect to resume the cycle of rate increases if the economy evolves as they anticipate, they view the current 2.25%-2.5% funds rate as close to neutral, or the rate that neither stimulates nor depresses economic growth.

As of December, when the Fed last published its summary of economic projections, the median forecast for the long-run neutral funds rate was 2.8%. At the time, policy makers expected to raise the rate two more times in 2019.

Based on the Fed’s new dovish tilt, the next official SEP, which will be released at conclusion of the meeting on March 20, is likely to reflect a slight downward revision to the long-run neutral rate.

Slow productivity and labor-force growth have conspired to reduce the economy’s potential growth rate and hence the neutral rate required to maintain maximum, non-inflationary growth.

How can we explain the chasm that exists between market expectations for the Fed and those of business economists? Our business gurus are looking for additional tightening, while fed funds futures contracts point to a higher probability of a rate cut in the latter part of 2019 and in 2020 than another increase.

In all fairness, business economists spend a lot more time thinking about … business than the ins and outs of monetary policy. For example, they pay a lot more attention to the effect of tax and regulatory policy on revenues and profits than to the impact of the Fed’s balance-sheet normalization or the implications of the Fed’s decision to maintain its current floor system for managing its benchmark rate versus its previous corridor system.

But business decisions ultimately depend on the outlook for the future. So sooner or later, the two camps will have to align with one another.

If business economists are so upbeat that they anticipate that several more rate increases will be needed before the economy succumbs to the pressure, maybe that’s a reflection of strong demand they are seeing for goods and services.

On the other hand, in a market economy, we rely on the price system to allocate scarce resources. Aggregate prices, which reflect the decisions of millions of households and businesses, contain a world of information and do a much better job than we humans with our comparatively narrow scope and limited faculties.

The Fed came around to Mr. Market’s way of thinking. Business economists may be next.



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