Column-‘Blunt’ interest rates raise questions about Fed easing: Mike Dolan By Reuters

By Mike Dolan

LONDON (Reuters) – If steep interest rate hikes have failed to slow the U.S. economy much in recent years, it’s reasonable to wonder whether their reversal will prove seamless in a recession.

One of the perplexities of the past two years has been how five percentage points of Federal Reserve tightening between March 2022 and July 2023 had such little effect on the overall economy.

Despite the tightening of borrowing, US real GDP has seen annualized growth rates of more than 2% in seven of the eight quarters since mid-2022 – and is on track to add to that number in the three months to the end of September.

And with all the seasonal swings, the stock market is near record highs.

This suggests that the economy has become increasingly desensitized to changes in short-term borrowing costs. If that’s the case, then policymakers should be concerned that any slowdown here – or even a cyclical recession – could also be accompanied by monetary easing.

Several theories abound about this resistance to high rates: the peculiarity of the COVID-19 pandemic years, including the ample household savings and government spending present before the tightening; the high level of US fixed rate debt, particularly mortgages; and high levels of corporate cash, which more than offset the hit small firms took from rising debt service costs.

The last of the three is perhaps the most remarkable. Net interest payments by US firms as a share of GDP have halved during the tightening cycle, according to a recent International Monetary Fund report. Other research shows that US firms’ net interest payments as a share of cash flow also fell from 2022 to the lowest level in nearly 70 years.

Low SENSITIVITY

So what are the implications?

Interest rates are clearly set to fall, and the Fed is expected to begin easing next week. But given the limited economic impact of rising rates, some analysts have argued that the U.S. central bank may have to push rates extremely low to stimulate the economy if a recession does indeed occur.

Others might argue that the impact of higher rates has just been delayed and that the lagged effect of the past two years is evident in the erosion of cash levels on some household and corporate balance sheets.

But corporate borrowers have little trouble rolling over their debt, even if they have to refinance at higher rates. Last week saw 59 new debt sales totaling more than $81 billion, the fifth-highest weekly volume ever for investment companies, according to IFR.

Some investors believe this complex picture should inject far more caution into the Fed’s thinking than markets are currently pricing in.

Yves Bonzon, chief investment officer at Julius Baer, ​​sees uncertainty about the transmission of monetary policy to the private sector as “very high”, largely because, he argues, interest rates have risen primarily to controlled “an income-based system, not a debt-driven economic expansion.”

“If the sensitivity of the real economy to interest rates is unusually low, it is unclear how asset prices will react if the Fed meets market expectations and cuts aggressively.”

Bonzon’s main point is that Fed easing in the absence of a recession can already spur an acceleration in private sector credit growth, boost housing and related sectors, and even revive the rate-hit leveraged buyout and private equity market.

“In this context, the Fed would be careful to avoid a cycle of boom and bust in asset prices,” he said, adding that to start cutting rates by three-quarters of a percentage point would be more than enough while the central bank of the US continues to evaluate things.

For BlackRock (NYSE: ) credit strategists Amanda Lynam and Dominique Bly, it all depends on what you think the Fed is actually doing here.

Is it getting easier to compensate for looming recessionary signs or is it just recalibrating now that inflation rates have moderated?

If it’s the former, then that could lead to deep cuts in the policy rate, but could also see a near doubling of high-yield credit spreads amid recession fears.

On the other hand, BlackRock strategists believe that if the Fed just “normalizes” here, its terminal rate will likely end up much higher, around 3.5%, and credit spreads stay where they are.

Regardless of your opinion, it’s clear that no one, including the Fed, can be entirely sure how this story will play out in the coming year. That means investors should expect more nervous months like the one we’re in right now.

The opinions expressed here are those of the author, columnist at Reuters

(By Mike Dolan; Editing by Paul Simao)