Special Encore: The Fed - Learning From the Last Hiking Cycle

Original Release on March 30th, 2022: As the Fed kicks off a new rate hiking cycle, investors are looking back at the previous hiking cycle to ease their concerns today. Head of Public Policy Research and Municipal Strategy Michael Zezas and Global Head of Macro Strategy Matthew Hornbach discuss.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.

Matthew Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley.

Michael Zezas: And today on the podcast, we'll be discussing the last Fed hiking cycle and what it might mean for investors today. It's Wednesday, March 30th at 11:00 a.m. in New York.

Michael Zezas: Matt, we've recently entered a new Fed hiking cycle as the Fed deals with inflation. But it seems like clients have been focusing with you of late on the question of what drove the Fed during the last hiking cycle, where they paused their tightening and started to reverse course. Why is that something investors are focusing on right now?

Matthew Hornbach: Well, Mike, investors are looking for answers about this hiking cycle, and a good place to start is the last cycle. The past week saw U.S. Treasury yields reach new highs and the Treasury curve flattened even more. Markets are now pricing Fed policy to reach a neutral setting this year of around 2.5%. The market also prices Fed policy to reach 3% next year. For context, the Fed was only able to raise its policy rate to 2.5% in the last cycle. So the fact that markets now price a higher policy rate than in the last cycle, after which the Fed ended up cutting interest rates, has people nervous. It's worth noting, though, that a 3% policy rate is still some distance below policy rates in the mid 1990s and the mid 2000s.

Michael Zezas: Got it. So then, what do you think of the argument that the Fed may have over tightened in the last cycle?

Matthew Hornbach: Well, instead of telling you what I think, let me tell you what FOMC participants were thinking at the time. I went back and read the minutes from the June 2019 FOMC meeting. That was the meeting before the Fed first cut rates, which they did in July. I chose to focus on that meeting because that's when several FOMC participants first projected lower policy rates. And according to the account of that decision, participants thought that a slowdown in global growth was weighing on the U.S. economy. In fact, evidence from global purchasing manager data showed that growth in emerging market and developed market economies was slowing, and was occurring well before the U.S. economy began to slow. And also, data suggested that global trade volumes were well below trend. So Mike, let me put it back to you then. It seems to me that Fed policy wasn't driving economic weakness back then, but that something else was driving this change in global economic activity. And I think, you know where I'm going with this...

Michael Zezas: Yes, you're talking about the trade conflict between the U.S. and China, where from 2017 to 2019 there was a slow and then rapidly escalating series of tariff hikes between the two countries. It was a very public pattern of response and counter response, interspersed with negotiations and sharp rhetoric from both sides, eventually resulted in tariffs on hundreds of billions of dollars in traded goods. Now, those tariffs endure to this day, but the tariff hikes stopped in late 2019 after the two sides made a stopgap agreement. But even though this was just a few years ago and perhaps seems tame in comparison to the global challenges that have come up since, like the pandemic and now the Russia-Ukraine conflict, I think it's important to remember that at the time this was a big deal and created a lot of concern for companies, economists and investors. You have to remember that before 2017, the consensus in the US and most of Europe was that free trade was good, and anything that raised trade barriers was playing with fire for the economy. We'd often hear from clients that raising tariffs was just like Smoot-Hawley, the legislation in the U.S. that hiked tariffs in many textbooks credit as a key cause of the Great Depression. So, as the U.S. and China engage in their tariff escalation and in many ways demonstrate, at least on the U.S. side, that the political consensus no longer viewed low trade barriers as intrinsically good, you have corporations becoming increasingly concerned about the direction of the global economy and starting to take steps to protect themselves, like limiting capital investment to keep cash on hand. And this, of course, concerned investors and economists.

Matthew Hornbach: Right. So this is more or less what the Fed suggested when it actually moved to cut its policy rate in July of 2019. The opening paragraph of the FOMC statement, in fact, suggested that U.S. labor markets remain strong and that economic activity had been rising at a moderate rate. But to your point, Mike, the statement also said that growth of business fixed investment had been soft. And in describing the motivation to cut rates, the statement pointed to implications from global developments and muted inflation pressures at home.

Michael Zezas: OK, so then if it wasn't tight Fed policy, it was instead this exogenous shock, the trade conflict between the US and China. What does that tell us about how investors should look at the risks and benefits of the Fed's policy stance today?

Matthew Hornbach: Well, it first tells us that policy rates near 2.5% shouldn't worry us very much. Of course, a 2.5% policy rate today may not be the same as it was in 2018 at the height of the last hiking cycle. It may be more, or it may be less restrictive, only time will tell. But we know the economy we have today is arguably stronger than it was at the end of the last hiking cycle. The unemployment rate's about the same, but the level of real gross domestic product is higher, its rate of change is higher and inflation is higher as well, both for consumer prices and for wages. All of this suggests that Fed policy could go above 2.5%, like our economists suggest it will, without causing a recession. But as the last hiking cycle shows us, we need to keep our eyes out for other risks on the horizon unrelated to Fed policy.

Michael Zezas: Well, Matt, thank you for taking the time to talk with me today.

Matthew Hornbach: It was great talking with you, Michael,

Michael Zezas: And thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.