Good or Bad: It’s All in the Framing

The Fed’s pivot to easier policy likely extends the current business cycle

As the global equity markets rebounded from their December 2018 lows, we have all have heard the constant refrain: Bad news being good news can’t last, the day of reckoning is coming.

That is, an equity rally built on the Federal Reserve’s pivot to easier policy is not sustainable. At some point, slowing economic growth will overwhelm the low interest rate policy and jumpstart an equity market correction.

While at first blush this may make logical sense, I firmly believe this argument suffers from a framing problem.

The basic premise of the argument is that the Fed’s pivot was driven by the US economy slowing to a catastrophic level – that is the Federal Reserve’s change of mind was driven by looking at an economy at a precipice. They know things about the economy that we mere mortals don’t and therefore a recession is imminent, and the Fed is reacting to that reality.

Again, in my judgement, framing the issue this way is entirely wrong.

Instead, a better way to think about it is in its Philips Curve driven doctrinaire thinking; the Fed got way ahead of itself.1 In the fall of 2018, they concluded that the US economy was out of the post-financial crisis. And, policy normalization, and even some overshoot on the tightening front, became the new mantra.

One doesn’t have to go back far to see the writing on the wall: In August to September 2018, the various Fed pronouncements were reminding us that they didn’t know where R* (the neutral Fed fund rate) was and, in their inflation driven tightening frenzy, they were going to go above that unknown neutral rate. 2

By December 2019, the Fed concluded that the US economy was slowing (and slowing fast) and inflation was as absent as ever. The right policy response in that environment, in their prudent and correct judgement, was to get off the tightening bandwagon. Thus, the Fed pivot.

If one frames the Fed pivot response in this slightly nuanced way, all the market happenings in the first half of 2019 start making sense and the outlook for the second half improves meaningfully.

In other words, in an environment of 3.5% unemployment rate and total absence of any inflationary pressures, tightening further and killing the US economy in the process didn’t make any sense. And a prudent Fed decided not to tighten further and started unwinding some of the unnecessary tightening.

If you agree with this framing of the current economic, market, and policy environment, then all of a sudden, the investment outlook improves substantially. The Fed will gradually unwind its last few rate increases in a prudent and methodical way–perhaps not the 50 bps cut the markets were expecting for the July meeting.  Financial conditions continue easing and in the second half of 2019, the economy will improve from its Q2 2019 soft patch, related to the inventory buildup in Q1 19, and get back to its trend growth rate of 2%. In that environment, the US equity markets rise despite some modest increase in US long interest rates.

And the current US business cycle, the longest in US history, continues–for five more years in my opinion.

1 The Philips Curve is the name for the theoretical relationship between unemployment and inflation in the U.S. economy. These two metrics have historically moved inversely with low rates of unemployment typically associated with higher levels of inflation.

2 R* is classified as the “natural rate of interest” or the interest rate that is neither stimulating or contractionary and would prevail when the U.S. economy was operating at full strength.

Important Information

Blog header image: Shahzin Shajid / Unsplash.com

The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.

Krishna Memani serves as the Vice Chairman of Investments for Invesco. In 2009, Mr. Memani joined OppenheimerFunds, which became part of Invesco in 2019. Before he joined OppenheimerFunds, he was a managing director at Deutsche Bank, heading US and European credit analysis. Earlier, he headed global credit research at Credit Suisse; was in charge of high grade and high yield portfolios at Putnam Investments; and was a credit analyst at Morgan Stanley.

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