Restrictive monetary policy = recession?

US President Trump has described the Fed’s present rate hike track as „crazy“, thereby expressing his dissatisfaction again with the central bank’s prospective path of gradual interest-rate increases. Trump is concerned that economic growth might suffer as a consequence. Indeed, the Fed is adopting a track towards normalising its monetary policy, having aligned it on a partly very expansionary course over the past decade or so. Not solely due to the US President’s remarks, we believe the question as to how long the Fed will retain its cycle of fed funds rate hikes will probably remain one of the most important topics in the financial markets over the coming months. Some concerns have also arisen among market participants that the Fed could pull too tightly on the monetary policy reins and choke off economic growth. Fears of exaggerated monetary policy tightening are not unfounded: past Fed interest-rate hike cycles show that the central bank with its monetary policy plays a crucial role in determining when boom turns to bust.

 

We believe the Fed’s biggest challenge will be to contain price and potential overheating risks at an early stage without jeopardising economic growth. This is doubtless no easy task. Past experience shows that a trend towards higher (or lower) inflation rates often proves pretty persistent. By contrast, monetary policy adjustments exert their effect with a considerable time delay. In the final analysis, the Fed must consider how strong the medium-term potential pickup in inflation will be in the current environment, and whether exaggerated price rises will occur in some sectors of the economy. We expect Fed governors to keep an eye on the relevant economic indicators in this context. Although the low unemployment rate and favourable employment trend tend to reflect demand-driven inflationary potential, we believe the risk of sharp upticks in inflation will be held within bounds thanks to the fact that wage growth remains only moderate. The Trump administration’s economic policy might exert an inflationary effect, however. We believe it is beyond doubt that fiscal policy spending will deliver an expansionary economic impulse overall. Not least, various companies have reported higher costs due to tariff-based trade obstacles, which have not yet impacted the general price environment. In the past, an expansionary monetary policy acting together with a similarly oriented fiscal policy has often led to a tangible uplift in inflation overall. In this environment, it should come as no surprise that the Fed, although acting cautiously, is raising fed funds rates at least slightly to within the restrictive range. We believe these fed funds rate hikes will play a crucial role in anchoring inflationary expectations. Maintaining price stability in this manner delivers greater prosperity than deploying fed funds rates that are too low, and then being exposed to the risk of having to step on the monetary policy brakes all the harder later. Not least, real yields, nominal economic growth and the stability of financial market indicators suggest further fed funds rate hikes, despite recent equity market volatility. The Fed has yet not held out the prospect of any significantly restrictive monetary policy level – as has been usual in the past. Similarly to the Fed governors‘ forecasts, we do not assume that inflation dynamics will increase so significantly over the next few months that the Fed would be forced to take preventative counteraction. We anticipate that the fed funds hike cycle will top out at around the 3.5% level. We believe that fed funds rate increases above the neutral level will not seriously jeopardise the economic outlook.

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