By Samy Chaar, Chief Economist

 

For the past 40 years every US recession has been preceded by a rise in real interest rates, triggering a sharp decline in investment and in durable goods consumption. Admittedly, the Fed has effected only four hikes thus far this cycle and, in real terms, rates remain negative. But the neutral interest rate level is lower today than in the past, meaning that fewer hikes may be enough to trigger a recession.

The Fed has made clear its determination to reload its guns – considering that ammunition (i.e. ability to loosen policy) will be necessary when the next recession does unfold. Without a rebound in inflation we doubt that the US central bank will be able to raise rates as much as it has communicated. Rather, we expect balance sheet management to become its main tool.

Will this unwinding of the Fed balance sheet affect financial conditions? 2018 and 2019 will undoubtedly see a reduction in central bank supplied money, to the order of USD 300-400 bn per annum, offsetting most of the credit created by commercial banks. That said, the pace of balance sheet reduction will remain measured. And whatever the growth in supply of US Treasuries, it should be absorbed by the banking system and foreign demand, limiting the impact on the yield curve.

On a different note, tax reform is back in the news. A politically complicated and drawn-out process lies ahead but we do expect some measures to be enacted before the November 2018 mid-term elections – notably on the corporate tax front. The direction being taken is one of pure tax cuts (financed by a larger budget deficit) rather than a broad (budget-neutral) revamp of the tax code. Note also that the scale and form of tax cuts will be driven by Congress rather than the Administration, given the former’s interest to score points ahead of the elections. And the end result will be much less impactful economically than President Trump’s original blueprint.

In fact, from a purely economic standpoint, the US is in no need of additional fiscal impetus. Fiscal authorities would be better advised to follow the Fed in keeping dry powder for when the economy stalls.

All told, the main risk lies on the monetary front and we will be closely watching for any signs of deterioration in financial conditions. For now, though, worrying about a recession in the US seems a little premature.