July 26, 2019 | 13:58
Once Upon a Time... of Fed Easing
The Fed is almost universally expected to clip interest rates at next week’s FOMC meeting, with most of the lingering debate now over the size of the first step, and whether it will be accompanied by any additional measures. For the record, we lean to a simple 25 bp trim to start, but readily recognize that the Fed has surprised many times on the easier side of the ledger so far in 2019. Looking beyond next week’s moves, the more interesting question is what comes next—will this be just the first in a series of cuts, how long will the easing cycle last, how might markets respond, and when could the Fed realistically begin hiking again? To address these issues, and many others, let’s look back at past easing cycles.
Below, in Tables 1 and 2, we consider the 12 separate and distinct easing cycles that can be identified over the past fifty years (Chart 1). Because rates were so volatile in the 1970s and 80s, and there were numerous mini cycles, we used changes in the discount rate to identify the start and end points of easing cycles for much of those two decades (and the Fed funds rate after the mid-80s). We have further split the easing cycles into mini and major cycles, with those with less than 100 bps of total easing placed in the first category (the shaded rows). The only one of the 12 which falls somewhere in between is the very first one in 1970/71, but it just qualifies as a major cycle (at 125 bps of easing from a starting point of 6.0%). Easing cycles are deemed to officially end only after the last rate cut before they started moving higher again.
There are a few major conclusions which jump out. First, the easing cycle itself:
Second, how the markets react:
We believe that this will ultimately be a mini easing cycle, officially calling for just one more move in October, although the market is priced for roughly 100 bps of cuts over the next year. The deciding factor for whether the rate cuts morph into a major cycle, not surprisingly, will be how the underlying economy fares in the next 6-12 months. While financial markets have tended to react in a reasonably uniform fashion after the start of easing cycles, the economy has not—in the four mini cycles, the jobless rate was slightly lower in the six- and 12-months after rate cuts began. However, in the cycles that morphed into major rate cut campaigns, the jobless rate was half a point higher six months after the first cut on average, and was almost a full point higher one year later. At this point, we are projecting just a 0.1 ppt increase in the jobless rate a year from now, and thus only modest rate trims; but we are also assuming no further deterioration in the trade wars.
Looking beyond this year’s expected rate cuts, if this does indeed remain a mini easing cycle, past episodes suggest that the Fed could conceivably be hiking rates again by late next year or early 2021. The typical easing cycle—both mini and major—has seen the Fed begin to tighten again within roughly a year of the last rate cut. Again, the glaring exception to the rule was the most recent cycle, when the Fed was forced to wait seven long years between the last rate cut in 2008 and the first rate hike in late 2015.
Bottom Line: There is no foolproof fixed playbook for Fed easing cycles, as every episode has its own quirks and special features. And there are some unusual aspects to the beginning of this Fed easing cycle—the extreme low starting level for both the jobless rate and interest rates. But, there are also many features that rhyme with historical precedent. Market behaviour has been close to the norm heading into easing campaigns, as has the trend in the jobless rate, at least compared with mini easing cycles... which this one is expected to mirror.
Coda: It may seem a tad surprising that the Fed is poised to ease just a bit more than 7 months after the December 19 rate hike. Yet, in the 12 easing cycles studied above, the median spread between the last rate hike of the prior tightening cycle and the first rate cut of the next was just 7 months (with a range of 1 to 18 months). So, from that standpoint at least, this cycle looks to fit the playbook perfectly.