« Exchanges at Goldman Sachs

What the Fed’s Hawkish Pivot Means for Economic Growth and Markets

2022-02-22

In the latest episode of Exchanges at Goldman Sachs, David Mericle, Goldman Sachs Research’s chief U.S. economist, and Brian Friedman, Global Markets Division’s global head of Market Strats, discuss how the hawkish shift in Fed policy is affecting economic growth, markets and investors.

This is an unofficial transcript meant for reference. Accuracy is not guaranteed.
This is exchanges of Goldman Sachs for reduced development, shaping industries, markets and the global economy? I'm Alison either a senior strategist in Goldman Sachs Research or on the cusp one of the largest monetary tightening cycles and we sit memory, the Federal Reserve, the European Central Bank and the Bank of England are all looking to accelerate the pace of policy normalization to help us make sense of the central. activity and the implications for markets and investors, I'm delighted to be joined by my colleague and Goldman Sachs Research, David Miracle, our chief- U S economist as walls, brine Friedman global head of markets? Droughts in are global markets. Division David, Brian, welcome to the programme, and you David
start with you. Your team recently raised its estimate for the number of expected Federal reserve interest rate hikes to a whopping seven hikes from expectations of just three hikes heading into the year. What's changed? That's lead you to make these ships are. A couple of things have changed. First, our assessment of wage Dynamics, look a lot more worrisome than we had previously thought late last fall. It seemed that, in the aftermath of enhanced unemployment benefits going away, wage growth was coming down to a rate that was compatible with the feds two percent. Inflation call. The wage numbers that we ve since the start of this year, in contrast suggests that the recent trend is about six percent, which is too high to be compatible with the two percent inflation target. On top of that work, strong and broader inflation trends, and, I would say, the combination of strong inflation, high wage growth and high short term inflation
politicians at the very least as a risk of being dangerous. The kind of classic wage price spiral concern, and I think for the duration of this year, the inflation numbers are likely to be high enough. That FED official they're going to see. It is appropriate to tighten steadily as Chair Powell has put it with twenty five basis points hikes at every meeting How does a little more about what you are expecting at this point throughout the year and in particular, at the march, a form see meeting which is coming up? Sure, there's clearly debate on the form about whether they should height by twenty five or fifty basis points. There is one FED official who's been arguing for fifty basis points. The bulk of them, though, seem to instead prefer to start with the twenty five basis points hike and to keep at it, but not to take the risk of doing too much too fast. So that's our forecasts that they will do a twenty five big pike and marched, followed by another tool. Five basis, point hike at the May meeting and then at the June meeting do both a twenty five basis, points, hike and start the process of reducing the balance sheet and so
just follow, but a context if they did hike by fifty basis points. That's actually pretty unusual cracked. That's right is, a long time since the fattest height fifty basis points at all, and I think it's been since the nineteen eighty is that they ve started a hiking cycle by fifty basis points now. You know I could certainly see if they go. Twenty five basis points at each meeting and it doesn't seem to be working if current wage and price dynamics persist. I could see how more members of the committee would be convinced that they need to consider other options, but for the time being, it doesn't look like that's how they prefer to start by. Let's bring you. The conversation, our clients and markets, interpreting and reacting to this hawkish. shift our genes and forecast, and also the signalling that coming directly from the fat sure so the first pillar,
you're. Naturally, look is the front under the yoke of ripe it has. The policy rate is the primary tool that the FED would be able to use, and each of us retain how many heights for the market is pricing and going into the September meeting in September of twenty one before they. started to pull away and prevent a move away from forward out, and you are praising almost less than one and now earlier this week you had to hit seven which matches the forecast Arab it a little bit over the last couple days. So now you have one hundred and fifty basis points president. For the year, forty six heights and total stuff. That's the first place that you were to see that the merger has obviously acknowledged the pivot that the third has made and was basically on board with the fact that there are gonna be going basically every meeting again. We're too shy about right now are J. The other
thing. That's noticeable is that the market has had a changed. Its perception of financial conditions right, so german power had mentioned in the January Preston, friends that the way that they expect policy to filter into the real economy is through financial conditions, and we know what financial conditions are made of right. So financial conditions in that made up of a rate component so short and rates and longer rates is made up of an equity component is made up of a credit spread component and the dollar is and improve their is well serve. One central banks are trying to ease monetary policy right you're, trying to lower rates to generate future growth.
fine to reflate assets and it's the reflation of those assets that provide some wealth. The fact that allows the economy to start to grow and, conversely, when they're trying to bring inflation down, they do so by trying to lift rates and trying to get assets to wealth destruction. If you will to some extent, and that provides a headwind to growth going forward, as we said the rate component now matches pretty much the pivot that the FED made. So there's been a big change and the rate component of financial conditions you can see, with an equity markets right, you can see that people have taken down their exposure. So nets right now or a year low, so people are no longer as bull as they were in equities, when the FED was trying to ease financial conditions over the past couple of years. You can see it in credit, where you ve, seen a record amount of outflows over the past four per week from both a g and high yield, and you can see.
In puts you so all of these kind of bows, elevated for Europe from a classic restore for a tightening of so condition so the market is much better position for tightening the financial conditions than they were colored six months ago were Eureka said David Irving, new back into this then, and, as you are looking at financial conditions, something that you are very focused on, how have they in aggregate responded at this point is what the FED is trying to achieve already happening. I would say that Striking thing is that we've undertaken this big hawk is pivot, that the market has taken it seriously, and then some pricing, six hundred and twenty seven hikes, and yet the tightening in broad financial conditions, at least as captured by our financial conditions index, is really fairly limited. So far it is there. It has happened over the course of this year, but it's not particularly large, and what that means is that the in as to the real economy is also not particularly large. So far, we estimate that the impulse to growth from Titan
and financial conditions that we ve, seen in the aftermath of the feds pivot, is worth about a one quarter to one half Savage point drag on growth this year. Now. Is that all or is that a little is that enough? Or is it not enough? It depends on what you think growth would have been in the absence of this financial conditions. Tightening our own view is a below consensus. Growth few were currently looking for two point: two percent growth that is inclusive of the tiny financial conditions we have seen so far, but the FED at least as of December, when they last submitted economic projections, thought they growth this year would be four percent. Now, if you decide that the economy is getting to a dangerous place. That further increases in the level of resource utilization that further tightening in the labour market against a backdrop of wage and price growth, that's already quite hot, is a dangerous thing. That's best avoided than you might be in a rush to slow things down to a point where the economy is growing at its potential pace, not faster, and if your belief is that the
enemy would have grown four percent while than you have an awfully long way to go, because we in fact officials think that the economies potential growth rate is below two, and certainly the tightening and financial conditions that we have seen so far. That quarter to a half point drag is not going to close the gap between therefore per cent forecast and that sub two percent rate of potential. Now, arguably that means you have to do more and its crucial to point out. That means you have to do more, not just than their already planning to do, but then the market is already expecting them to do, because if the market is anticipating that you have something similar to our forecast of seven rate hikes, there's no off His reason that delivering on vat should have an appreciable further effect in tightening financial conditions. You would need to surprise the market by doing more right, I mean why explain the lack of response in the market. Have you looked at that is difficult to say,
you know I would say to some degree. Some people seem to imagine that the FED simply can't take rates above a certain level, so that more tightening now perhaps means less later. Some people might think. Yes, I can envision a scenario where high inflation generates much higher fed funds rate, but if there's a good choice, and that that is sort of an out of control scenario that leads to recession? Then you might have a higher funds rate, but not for very long, and so the transmission to longer term rates wouldn't be very high because sure the funds re gets to a high level. But if it only last for a year or two, then it's not a very large share of say the average rate over the next ten years. There could be a number of other things going on, but for now it looks like the feds rather considerable pivot in the market. Taking that seriously has not really been enough to have a large negative impact on the real economy, growth rate, while they get very aggressive, as we already anticipate, but potentially even more aggressive, and we are already looking at fiscal stimulus, fading
as we are emerging from the pandemic era, stimulus that was provided, in twenty twenty and into last year. Are you worried that we actually could be looking at it? this recession risk at this point. What's the likelihood that we end up back in recession, where I think enough, there's thing we ve learned during the pandemic. It's that it's a lot harder to do economic forecasting than usual that the big factors that matter for the economy this year are very large risks and very uncertain risks. We estimate a very large, roughly four percentage point fiscal drag. Our best guess is that other positive forces incremental reopening of the economy further spending accumulated access, savings, rebuilding of inventories and so on, will offset those negatives. But a lot of these things are now a little bit hard to quantify. We don't really have modern parallels, for example, to the excess saving story that right. opening story a sort of prisoner to developments with the virus itself. So there is,
think more uncertainty than usual and that very large fiscal drag is, I think, a substantial downside risks certainly a much bigger risk than anything I had to contemplate as a forecaster in twenty seventeen or twenty thousand and eighteen or twenty nineteen now It is certainly not the feds intention at this point to induce a recession. They are rightly, I think, worried about price and wage dynamics, as are we, but they certainly have not concluded that the only way to deal with them is by inducing a recession. So if it looks like the economy is flirting with recession, I think they would back off. In my mind, then fiscal policy tightening is actually a bigger risk than monetary policy tightening both because we estimate that the impact on the economy of fiscal tightening is much larger than the monitor policy tightening we expect this year an because,
I would suspect it's less likely to be flexible. If the FED thinks it's overdoing it, I could see them slowing the pace to once per quarter or backing off entirely. If it look like serious downside, risks to the economy were emerging, whereas I dont think we're going to get a sudden round of massive fiscal support. If it looks like the pull back and fiscal support has overdone it and threatens to push the economy to a very weak place. By Are you hearing from clients? Are you hearing any rumblings about its concerns about the growth outlook servers concerns about recession. Breast fried and you could even see within the yield curve it slightly inverted where the yield of late twenty three is higher than the yield of a twenty four, so you're, actually pricing in at the feds in a hike and then they're going to have to cut over the course of twenty four in large part b. of the worries about recessions, I would say that this is very much in line with past. Heightened cycle is right. If you look at how rates performed in past, hating cycle is what you notice tunnel definitively happen.
This is two things the yield terms flattened and that the market significantly under prices. The level at which the fat is gonna. Get to this time around which interesting about the curve, maybe is that you flattened two levels where you usually end hating circles before the fat has doled out the first time, but we don't they that's a huge opportunity there. What is a bit opportunity is the fact that we felt like the last to heighten cycle is the market has significantly underpriced where the FED will have to get to and really why the market does. That is because China, by contract, you are hiking into slower growth and the more It always is a little bit worried that a slower amount of hydra, less amount of heights war kind of accelerate the deceleration and will force you to stop at a lower level than as David was alluding to bees rate hides. Don't have a major effect on
inflation rate or the growth rate at the very beginning, and if you think about what the fairies telling you they're more worried about the other scenario where with an inflation, don't come down as much as need to write and they're. Gonna have to go deeper and their presented with a bigger bit of a problem, because, If you think about it, like the building blocks of growth are actually pretty healthy already growing above trend? Does David alluded to you have an inventory cycle ahead of you. Anyone who wants a job has a job at higher wages than you had before the pandemic financial, decisions are still easy rates is still very low. All of these things, none of them really for bird of recession, that's gonna happen at a relatively low level of right. Right gave again thanks to that Amene, ultimately the underlying economy does look in reasoning good shape yeah, I think that's right.
at the moment is somewhat difficult to interpret the data because of the effective Almah crown which looked short, lived but serious in some areas, and I dont think we ve seen the full impact by any means of the pull back and fiscal support. I think that will evolve gradually over the course of the year, but yeah for now the economy grew strongly in too, for it looks to us like it will grow at a decent pace of about two percent and two one. I think that the rate of growth this year is going to be much slower than we became accustomed to last year and slower than consensus expects by were certainly not calling for a session. Brian. You mention that you think longer dated interest rates at the long under the Ford curve are too low relative to what the FED is likely going to have to do over the course of this cycle. Is there anything else off that looks at Miss used to you, and you know: how are you advising clients to position themselves at this point to end may be hedged some of the risks, maybe not mainline scenario, but some of the risks we discussed sure well before
thing is that you do have to be cognisant that the FED is trying to inflation down from seven and a half to two over a reasonable amount of time, and you would have to its back there in order to accomplish that. You're gonna have the high grade take out accommodation potentially going through restrictive and tightened financial conditions right up again finance? four conditions generally means all assets down with it the bastion of financial conditions. There are clearly some that we think are more vulnerable than others, as I alluded to reach would be a big one of those right now. You're, essentially saying that the feathers in a pick out at around two percent, with inflation well above two percent, that still leaves real rates, deeply negative, it's hard to imagine that leaving deeply negative rates, The economy is going to be enough to pull inflation down as fast and as far as the FED wants it too. So if we still think that short rates is a high quality trade, I think
Of all of the assets that are maybe most vulnerable within a financial condition, tightening its credit. I think that when you, look all in credit. I think the market has been trained to view credit. we through the lands of the false, if companies are not going to fall, Then you're money is good and largely been true but it's very much true, because rates have been coming down for thirty years. So as long as rates are coming down. Your credit we're folio is gonna, be all tat. This time around, though you're coming from a place where both rates are record, lows and credit spreads were at historic ties in the middle of the pandemic, because the FED did something that they never did before, which was tunnel backstop credit. So now you, when you look at all in credit, so just get ten year ban for an energy company all in re, both the rate component and the credit components are very low and receiving. Is that if your long, a portfolio of credit you
vulnerable to just growth, being an inflation being very high and just town of a clip senior yield. So It's already down seven percent this year and you still have to pay your seven send information, though, on top of that- and you have already started to see a significant amount of outflows, so in a world in which the FED is telling you that they want to tighten financial conditions which are bad for spreads by high degrades, which is bad for the re component. We don't see what the advantage is or what the upside is for holding a portfolio credit, and if there was one answer given that its along only asset where, if you start material outflows and asset managers of have to get out the clearing level just a little bit fuzzy of where the next buyer will command. We think that's the asset that is most at rest of the world and the financial condition tighten or trade equities. We have a preference for over a credit just because equities
our real assets, who, in a world where nominal growth is still good and richer, still relatively low, that still kind of a talent for equities and corporates are in very strong shape, with respect to both earnings, growth and margins. So we much prefer the combination of being long equities. Hedged were short credit. Interesting The other point that you brought up in the context that conversation was the fact that you mentioned this mechanics of credit by David David. The other big aspect of the FED tightening cycle will be balance sheet. You note shrinking the balance sheet does even some discussion of not only bowling off assets from the balance sheet, but even actively selling the balance sheet. If there is more work to do to tighten financial conditions, what are your thoughts and expectations around that side of things and bind turned you and talk about the implications of losing that big buyer in the bond market. I would think of ballast
reduction is very much a secondary tool in terms of monetary policy. Tightening relative to interest rate policy. Are estimates suggest that the impact of balance sheet reduction should be equivalent of something like thirty basis, point rate hike and with seven hikes for this year are forecast, calls for a hundred seventy five basis points. A rate hikes show that would account for the great bulk of the tightening. I think they'll start this since those sometime around the middle of the year. We expect them to shrink the balance sheet. Ultimately, from about eight point, eight trillion today down to the low timid six trillions that is about three to four times as much in dollar terms as they did last cycle. So it's a lot more. I would also expect them to go more quickly than they did last cycle at something like double the peak pace. Maybe a peak pace of a hundred billion dollars per month. If they do,
do that, it would simply take a very very long time, and I think they want to get this done on a reasonable time horizon. My senses that most investors would not be particularly surprised if the FED delivered a balance sheet reduction plan along the lines that I have outlined, and in that sense I think it's plausible that much of the impact is already priced and that if the FED does deliver something like what most of us are anticipating the further incremental impact. That would not be particularly large in the same way that delivering rate hikes that the market is already price should not have a large impact on markets by and by At the end of the day, we are losing this big fire bonds in the market some people have actually argued, has somewhat distorted the bond market EDA over this period. What do assess to be the implications of that? They are so I do agree with ever that the federal used the policy rate as their primary tool. However, we do have to be cognisant of the thing that different going into this hating circle is just
Inflation is just much higher than we ve seen in the past forty years right. So it's very hard to come heard the last to heighten circles, especially the last taken Psycho, where they were well before you ever had inflation to this one. I think David brought up the key point before where the key part of this year will be as you go into the second half when both the FED and the markets that's for inflation to come down pretty meaningfully by its inflation. Is not coming down as quickly as either FED or the might yet its. Then everything has to be on the table for the FED beer bonds be a faster pace of rate higher. they're gonna need to get rates higher much higher than what price and they're gonna have to use all of these tools. So I think it's, the combination of if there are selling bonds. That means that inflation has not come down as much and chances are there also going to be hiking were, and we do have
be communists that it's not just the fat right. It's all of the major central banks that are walking away from tee. We and turning to cute, in a much tighter timeframe. Then we ve ever seen before again. It's just one more reason why we think that being short rates is a high quality trade and that the market is just miss pricing, the rate at which the FED will be able to get paid to left end with it put discussion on emerging market, central banks, because it's an interesting situation in the sense that emerging markets are the banks usually start to tighten after develop market central banks. This time around, it looks like an emerging market. Central banks are more in the tail end of their tightening cycle. So what are the implications of that? It says you think about differentials in yields across geographies. This time was a little bit different in that during the peak of the recession, who had em central banks do with this
Thirdly, what their DM brother did, which was just cut rates as lowers you can't write, usually when you have a shock, they have to keep rates higher or even higher in order to make sure you don't have capital outflows puts up the fact that they cut. such low levels, coupled with the fact where Dm Central banks switched to average inflation targeting where are they allowed themselves to stay lower than usual right, while DM central banks have the credibility to stay,
low in the face of high inflation and central banks are not afforded that same luxury, and therefore central banks had the height much earlier and much higher than either day or the market thought that they were going into last year. So it's been a pretty impressive hiking cycle and because of the fact that now im central banks or at the tail end of their hiking cycle, while DM central banks are just beginning, its leaving rate differentials are very, very high levels, and because of that, we think that buying either he am currencies were young. Local bonds is actually a pretty safe place to hang out right, because if, in fact, inflation doesn't fall as as what's priced into these inflation markets, then DM central banks are gonna have to hide a lot more than words priced. While it is not clear that central banks have to hide a lot more from these levels, and if I do
an efficient markets are right and inflation dose for starting the end of the year pretty meaningfully, then it's not clear that dear its have to rally at all from here, while m rates will look high from these bubbles, so it very wide break differentials in that just presents an opportunity to hang out in those markets while you wait to see, but the insane and you're gonna have to do over the course of the year How very interesting will be watching. We have a few big up coming such a big meetings that we will be monitoring quite closely. Thank you, David and Brian, for joining us today. Thank you for that who's. This episode of exchanges of Goldman Sachs things for listening, and, if you enjoyed this show, we hope you subscribe Apple, podcasts and only by rating and comment. This podcast was accorded on Thursday every seventeenth, twenty twenty two
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Transcript generated on 2022-02-24.