5.9 C
New York
Friday, March 29, 2024

How A 150bps “Rate Shock” Would Hit The US Economy

Courtesy of ZeroHedge. View original post here.

In one of the more whimsical notes published by Goldman in recent months, chief economist Jan Hatzius writes that he has received numerous questions about various “rules of thumb” for analyzing the US economy, and lays out a selection of these rules, covering Fed policy, financial conditions, growth, unemployment, inflation, bond yields, and recession risk.

While the note covers everything from monetary policy (in the context of rising rates) and the impact on financial conditions, to the labor market and the relationship between GDP and the unemployment rate, to the link between the unemployment rate and rising wages and overall PCE inflation, eventually closing the loop with the Taylor rule and how a mechanistic take on the economy translates to monetary policy, perhaps the most interesting aspect of the note is Goldman’s take on what a 150bp “unexpected increase” in the Fed Funds rate would do to both financial conditions and GDP.

To be sure, unlike 2 months ago when discussions about the “overheating” of the US economy were all the rage, and some were even hinting that the Fed may engage in one or more surprise rate hikes, in recent weeks the US economy has shown troubling signs of a slowdown and as a result the conversation has shifted away from unexpected tightening to whether Powell may in fact terminate the Fed’s tightening prematurely, the Goldman analysis is still interesting, if more as a thought experiment; it would certainly be relevant once more from a practical standpoint should high frequency economic indicators suddenly surprise to the upside in the coming weeks.

In any case, according to Hatzius, who notes that “the funds rate alone is no longer a reliable predictor of financial conditions”, Goldman observes that monetary policymakers now affect GDP by influencing financial conditions. Specifically, according to Goldman calculations “a 150bp hawkish funds rate shock typically tightens the FCI by 100bp. By component, a 150bp hawkish funds rate shock tends to increase the 10-year yield by 45bp, lower equity prices by 9%, and raise the value of the dollar by 4%” as shown in the chart below.

While hardly a surprise that substantially tighter financial conditions – as a reminder 150bps is 6 rate hikes – would have an adverse impact on the economy and markets, Hatzius notes there are two important caveats to his analysis.

  • The first has to do with whether the rate hike is truly an unexpected surprise “since anticipated funds rate hikes are typically already priced in bond, stock, and currency markets, they have much smaller effects on financial conditions and growth than unexpected shocks.”
  • The second has to do with what other factors are at play as “Fed policy accounts for only a relatively small part of the ups and downs of financial conditions, since other factors such as risk premium shocks are a major source of FCI fluctuations. Therefore, the relationship between Fed policy shocks and the overall movements in financial conditions is far from stable.”

Furthermore, as a direct result of the rate shock – by way of tighter financial conditions as a transmission mechanism – GDP growth would also be affected.

As shown in the left panel of Exhibit 3, we estimate that a 100bp FCI tightening shock gradually leads to a peak GDP hit of just under 1pp after 4 quarters, before leveling off in the second year.

Goldman notes that its statistical estimate of the FCI impulse on GDP growth “is well approximated with a rule of thumb. As the right panel of Exhibit 3 shows, the FCI impulse on sequential GDP growth is typically roughly equal to -2/3 times the actual year-over-year change in the FCI.”

That said, the bank’s economists caution that relationships between the different factors change over time and aren’t always linear, and that financial conditions are affected by many things other than Fed policy such as risk premium shocks.

Among some of the other “rule of thumb” observations discussed by Goldman are the followingL

  • A 1pp fall in the unemployment rate raises wage growth by 0.35pp, but tends to lead to a more modest 0.1pp rise in core PCE inflation and a 0.15pp rise in core CPI inflation.
  • A 10pp tariff hike on $100bn of imports tends to raise core PCE inflation by 0.02pp.
  • A 1pp fall in the unemployment rate gap—the difference between the unemployment rate and the rate of unemployment consistent with 2% inflation—raises the prescribed funds rate by 100bp and 200bp, respectively.
  • A 10bp increase in core inflation leads to a 8bp increase in the 10-year yield with a 3bp contribution from a higher term premium and a 5bp contribution from a higher expected nominal funds rate.
  • A 1pp increase in the budget deficit raises 10-year interest rates by about 20bp.
  • A 1% of GDP purchase of assets by the Fed tends to depress long-term bond yields by around 4bp (with the effect on US rates from purchases by central banks abroad being roughly half as large).

These and other “rules of thumb” are summarized in the table below:

Finally, addressing the question on everyone’s mind, what is the risk of a recession, and implicitly, whether the Fed will “tighten” into one, Hatzius writes that since recessions are notoriously difficult to forecast, the bank “monitors recession risk with multiple tools, including a bottom-up dashboard, economy-wide and sector-specific private sector financial balances, a cycle classifier, and a top-down model.”

Her’s what the bank’s models reveals: over the course of 2018, the estimate of recession risk has nudged up across horizons. Specifically, for the two-year horizon it has increased by roughly 5pp to 26% (with a 3pp contribution from the 1.1pt FCI tightening and a 1-2pp contribution from a 0.7pp bigger output gap). Meanwhile, two-year recession odds are still below the unconditional average, while “the three-year probability has risen by 7pp to 43% and now sits just above the historical average.”

According to this analysis, Goldman is not concerned that a recession is a credible risk any time before 2021, which may also explain the bank’s surprisingly optimistic outlook on the economy in 2019 when the bank still expects the Fed to hike rates 4 times even as the market is on the fence whether Powell can pull off more than even one rate hikes as of this moment.

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Stay Connected

157,449FansLike
396,312FollowersFollow
2,280SubscribersSubscribe

Latest Articles

0
Would love your thoughts, please comment.x
()
x