The anatomy of a mini rate cycle

| July 26, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The Fed ease widely expected on July 31 looks like part of a limited insurance move. The Fed wants to recalibrate policy somewhat in hopes of preserving growth when the risks of a run-up in inflation seem minimal.  Most rate cycles in modern times have been an extended string of moves in a single direction, so there is not much historical precedent for a mini-cycle.  The current episode feels like a slow-motion version of the limited easing in 1998, and whatever cuts take place in the near term are likely to need to be reversed in relatively short order.


Beginning in February 1994, the Federal Reserve tightened policy sharply, raising the funds rate from 3% to 6% over 12 months in an effort to pre-emptively stave off inflation.  Real GDP growth slowed from over 4% in 1994 to below 1.5% in the first half of 1995, with the manufacturing and housing industries hit especially hard.  The unemployment rate backed up slightly in early 1995, while core inflation inched lower over the course of the year.

Given these signals, the Fed reversed course, easing three times by a total of 75 bp between July 1995 and January 1996.  The Fed’s decision may also have reflected a desire to support the economy in light of uncertainty created by the federal government shutdowns of late 1995.  In any case, a modestly lower funds rate target of 5.25% apparently suited the economy well.  A somewhat easier monetary policy accompanied by a resolution of fiscal uncertainties helped to get the economy back on track in 1996.  Real GDP growth re-accelerated to more than 4% on a trend basis and stayed there for the remainder of the decade.


Throughout the late-1990s, the economy was expanding at a robust clip and the unemployment rate was sliding. When the jobless rate dropped below 5% in 1997, it was at its lowest level in nearly 25 years. But inflation was not responding as the Fed’s Phillips Curve models would suggest.  In fact, core inflation gently trended lower through much of the 1990s.  Chairman Greenspan was able to sniff out the tremendous acceleration in productivity growth during that period that made robust growth not as inflationary as it may have appeared at first glance.  This helps to explain the Fed’s relative inactivity for much of 1997 and 1998.  Frim mid-1996 through mid-1998, the FOMC signified a tightening bias in 14 out of 17 meetings but only actually hiked once.  That single move came in the form of a 25 bp rate increase in March 1997, the first of what seemed likely to be a series of hikes designed to cool the economy off before it overheated.

The March 1997 rate increase, however, ended up being a one-and-done move, as the Asian financial crisis of 1997 began in July with the collapse of the Thai Baht.  Currency woes spread to Indonesia, South Korea, and others in the region.  Fed officials were quite concerned at the time that the U.S. economy would suffer from a softening in foreign economies, though, in retrospect, those fears did not come to fruition.  While U.S. exports did soften for a time, domestic demand was sufficiently torrid to sustain real GDP growth over 4%.  Even so, the Fed did not tighten again in 1997 or 1998, perhaps partly out of fear that such a move would further destabilize the vulnerable Asian currencies and economies.


Overseas turmoil reared its ugly head again in the summer of 1998.  In August, the Russian government devalued the ruble and defaulted on some of its debt.  This move sent ripples throughout a financial system that had gotten very levered.   The poster child for this leverage, Long-Term Capital Management, collapsed in September 1998 and the New York Fed was forced to gather the hedge fund’s Wall Street creditors and broker a bailout.  These events sent financial markets into a frenzy, as the S&P 500 index dropped by nearly 20% over six weeks in late July and August, while 10-year Treasury yields plunged from almost 5.5% in early August to as low as 4.16% in early October.  Chairman Greenspan and the Fed rode to the rescue in the fall of 1998, cutting rates at the September 29, 1998 FOMC meeting, again between meetings on October 15, and a third time at the next FOMC gathering in November—three rate cuts in seven weeks.

Financial markets recovered quickly.  The S&P 500 index rebounded by close to 30% in less than three months, ending 1998 almost 50 points above its pre-summer-meltdown highs.  The Fed’s actions were taken with one eye on the fragile financial markets but primarily out of fear that the gyrations on Wall Street would torpedo the economy.  Once again, those fears would prove unfounded.  Amazingly, in the midst of market turmoil, real GDP growth was more than 5% in the summer of 1998 and over 6½% in the fall – and continued to post extraordinary growth non-stop until the expansion finally petered out at the end of 2000.

After its lightning-fast easing response in the fall of 1998, the Fed was slow to signal the all-clear.  It was not until June 1999 that the Fed began to hike rates again, by which time the S&P 500 had rallied another 10% and real consumer spending had clocked a fourth quarter out of five with growth of more than 5%.  In fact, it took a full year from the third rate cut in 1998 for the Fed to get back to the level of the funds rate before the summer of 1998.  While inflation was stunningly low throughout this period, in retrospect, the Fed’s unwillingness to restrain the economy arguably fueled a reckless easing of financial conditions that ultimately set the stage for the NASDAQ bust of 2000.

What can we learn from these episodes?

Every economic cycle is different, so there is never a perfect historical analogy.  That said, as the saying goes, “those who do not learn from history are doomed to repeat it.”  Drawing comparisons from the 1990s to today highlights some of the fault lines between the different camps today.  Many of the more pessimistic forecasters fear that the economy is on the cusp of a possible recession and needs aggressive Fed easing as soon as possible, although the most aggressive critic of the Fed, President Trump, clearly does not subscribe to this view.  For those, the current situation probably looks most like 1995, when a tight Fed jeopardized the expansion but a modest downward adjustment in rates helped to extend the economy’s health for years to come.

In contrast, many others, including me, believe that the economy is largely in good shape but is simply being temporarily dampened by uncertainties around trade policy.  My camp would argue that the current episode looks most like 1998, when the Fed shifted to an easier stance to bolster volatile and potentially vulnerable financial markets.  Indeed, in my view, the case for an easing today is far less compelling than it was in 1998, when one could at least see a clear path to a financial crisis.  Moreover, as in 1998, the Fed has been dissuaded from raising rates despite a super-low unemployment rate and above-trend GDP growth by the fact that inflation has been running low.

In my view, as was the case in 1998, the risk of the FOMC easing significantly in the current scenario is not so much that inflation will run away, as in the 1960s and 1970s, but that financial conditions will become excessively easy, sparking a speculative frenzy that ends badly, as was the case in 2000-01 and again in 2007-09.

In any case, one’s view of how the 2019 easing cycle will play out depends on how one sees the underlying situation.  Those in the fundamental weakness camp expect that the Fed will have to lower rates substantially to spark growth in the midst of lackluster housing, manufacturing, and investment activity.  Fed funds futures clearly favor this scenario, as investors are pricing in about 75 BPs of rate cuts over the next 6 months and close to 100 BPs of cuts over the next 15 months, with virtually no reversal over the following couple of years.

However, I would argue that the current episode feels like a slow-motion version of 1998, where the Fed will ease in July and will only cut again if the economy and/or markets continue to look vulnerable in the months ahead.  The Fed might be able to sneak in one or two more cuts—say, in September—before a China deal is done and leads to a sharp pickup in growth or before core inflation makes more progress toward 2% or before it becomes evident that real GDP growth this year will clearly exceed policymakers’ expectations even with the drag from tariff threats, though my current call is for July 31 to be a one-and-done move.  Moreover, whatever cuts take place in the near term are likely to need to be reversed in relatively short order.  As was the case in the aftermath of the 1998 easings, the additional stimulus injected into the system will only add to momentum that will eventually need to be arrested.  After waiting too long in 1999 to take back the 75 bp of easing, the FOMC was ultimately forced to hike the funds rate by 175 bp all the way to 6.50% in 2000, as stock prices ran up by more than 50% in 18 months from the fall of 1998 and the economy roared.  In the current episode, the economy continues to run at a clearly above-trend pace, halfway to the third straight year of at least half a percentage point above the Fed’s projected long-run trend, while the unemployment rate is near a 50-year low, perhaps soon to slide to a 65-year low, while financial conditions are very easy, but once the FOMC initiates an easing cycle on July 31, even if it turns out to be brief, rate hikes are probably going to be out of the question for at least six months after the last rate cut.

john.killian@santander.us 1 (646) 776-7714

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