Growing Pains

--big risk for med term growth is policy mistake, hiking rates prematurly --GDP and ISM growth usually preceded rate hiks by 1 year. but rate hiks concides with inflation expectation September 24, 2009 By Manoj Pradhan London Risky asset markets are booming, US growth is set to resume with a bang in 3Q09 and the ISM has bounced solidly off its lows. Yet central bank officials have remained active in warding off attempts by markets to price in early hikes in policy rates. Experience from the previous three recessions in the US suggests that the Fed is likely to look through improvements in GDP and the ISM. Instead, its rate hikes have coincided strikingly with an upturn in inflation expectations. In our view, the biggest risk to medium-term growth is a policy mistake. Stronger-than-expected growth over the next few quarters may lead to a rise in inflation expectations, which may in turn prompt a premature start to the tightening cycle, as it seems to have done in the past. ‘Stylised facts': Using the previous three US recessions as a guide to possible exit policies, a few important ‘stylised facts' assert themselves: • A resumption of growth and an upturn in business sentiment predate even the end of easing, and lead the beginning of rate hikes by long intervals; • The end of easing and the trough in policy rates occur about a year before the Fed starts hiking rates again; • Rate hikes by the Fed occur around the same time as the upturn in inflation expectations with striking regularity. A revival of growth has not triggered rate hikes in the past... GDP and ISM turnarounds on all three occasions preceded even the end of the policy rate cuts. Rate hikes were, on average, about a year further away. The fact that the Fed waited for a significant period of time beyond the trough in growth and business sentiment provides a gauge of how long it takes to ensure that recovery is entrenched and able to withstand a withdrawal of stimulus. One reason for this is that the early part of the recovery is usually based on this policy stimulus. A further reason is that disinflation usually continues well into the early recovery phase. Policymakers ideally start withdrawing stimulus only when growth is self-sustaining and inflation looks poised to increase. This time is no different in that regard. Our US economics team expects growth to resume with a strong start in 3Q09 but still see a policy exit a long way away (see Fed Exit Strategy Still Far Off, Richard Berner and Dave Greenlaw, September 21, 2009), with the first rate hikes coming in 3Q10. The rate hikes will arrive about 11 quarters after the start of the recession - bang in line with past experience. The upturn in GDP and ISM, however, has taken longer to materialise, which means that the interval between a turnaround in output and sentiment and the first rate hike is shorter in this recession than it has been on average in the past three cycles. Why? The massive monetary and fiscal stimulus provided to the global economy has led to a resumption of growth sooner than would have otherwise been possible. This time around, central banks are likely trying to find a balance between waiting for a self-sustained recovery and not waiting too long and risk stoking an asset price bubble. Unless, that is, the stylised relationship between inflation expectations and policy rate hikes reasserts itself and forces their hand. ...but rising inflation expectations seem to have been a trigger: While the trough in output and business sentiment led rate hikes and even the end of rate cuts, the trough in inflation expectations has coincided with the beginning of policy tightening on every occasion in the previous three recoveries. There is reason to believe that policy rates were reacting to the rise in inflation expectations. On each occasion in the past, the increase in the fed funds rate has at least been equal to the rise in inflation expectations, and rates have risen at a faster rate in the last two episodes in order to raise the ex-ante real interest rate. It is still possible that this survey measure of inflation expectations was reacting to the same strengthening fundamentals that drove policy rates higher (i.e., we could be mistaking correlation for causation), but the consistency in each recession of the timing and the speed with which policy rates were raised makes such a caveat less likely to be true, in our view. Comparisons with the past are not easy... It is difficult to compare monetary policy in this cycle with the past because the monetary stimulus has been markedly different. Policy rates of all major central banks are very close to zero while monetary easing is still being delivered by central banks via their ongoing QE programmes. The end of rate cuts as they approached zero cannot therefore be considered the end of easing. The time between the end of easing and beginning of tightening is therefore even smaller this time around. On the way up, raising rates is going to be that much trickier thanks to the need to unwind active QE. Looking at the policy rate profile of central banks who have adopted QE measures will therefore provide only part of the story because those hikes will be influenced to a great deal by how successfully central banks are able to negotiate unwinding their QE purchases. ...but while history may not repeat itself, it may rhyme: On the evidence, it is difficult to rule out the possibility that a premature start to the hiking cycle could be precipitated by an earlier-than-expected rise in inflation expectations. The base case from our US team is for headline CPI inflation and core inflation to breach 2.5% and 2%, respectively in 2011 but remain stable and benign. However, given the rapid growth of narrow money in the economies where QE has been adopted and the difficulties surrounding policy tightening (see "QExit", The Global Monetary Analyst, May 20, 2009), the risks to inflation are likely biased to the upside. In a recent note, we pointed out that the biggest risk to medium-term growth was from a policy mistake, most likely through an aggressive response to stronger-than-expected growth in the near term (see "‘Up' with ‘Swing'?" The Global Monetary Analyst, September 16, 2009). Such a ‘blow-out' scenario is not our base case, but the policy stimulus has produced upside surprises so far and there is no obvious reason to think that it will find less traction going forward. If growth were to surprise to the upside, rising inflation expectations would be a natural response. Rising inflation expectations seem to have triggered rate hikes in the past. They might well do so again.