Fedophobia

In a report published Friday, Bank of America analyst Ethan Harris explored the "what's next" scenario as the Federal Reserve's September rate hike isn't completely out of the question.

Harris may have been the first to coin the term "Fedophobia" back at the end of July when he noted that the FOMC sounded "cautiously optimistic" over the data it is seeing and that the Committee need only see "some" additional labor market improvement before a rate hike.

Harris continued in his July note that the "shock" to the markets and economy should be "quite small," and fears are overblown. In fact, the equity market is still expected to yield a "modest" single-digit return in 2016. At the same time, bank lending will continue, as they have "come a long way" in dealing with legacy loan problems, increased capital requirements and legal challenges.

Related Link: Federal Reserve Update On Leaked Staffer Economic Projections

Harris further noted that the Fed is "well aware" of the potential consequences of "taking the economy off life support" and has adjusted its strategy accordingly to "minimize the risk of a shock."

"They are carefully telegraphing their intention to go slow," Harris wrote. "They are promising to maintain a big balance sheet until they are sure the rate hikes are being comfortably absorbed. And the spillover from aggressive QE in Europe and Japan should cushion some of the impact of Fed tightening on US capital markets."

Most importantly, he added, is the fact that the Fed is entering the cycle with core inflation running at the slowest pace since the 1960s, which allows them to stick to a "slow" exit plans.

Life After The Hike

In Harris' most recent note, he explored the "life after the hike," having already argued that the first year or two post-hike should be "relatively benign" for both the economy and markets.

However, what comes next could "get interesting," as the key issue will shift to how soon the economy hits its "inflation speed limits" and how quickly inflation picks up once the limits are hit.

"Above-potential growth causes a steady drop in the unemployment rate, with the speed of decline dictated by the size of the gap and by "Okun's Law," Harriss discussed. "As the unemployment rate breaches the inflation-neutral "NAIRU," core inflation starts rising. The pace of acceleration depends on how far unemployment falls below NAIRU and on the slope of the "Phillips Curve." Finally, external shocks can alter the path for inflation, with a particularly strong impact from the dollar and import prices."

Harris continued with specific estimates for each parameter:

  • Potential Growth: Potential growth will "probably" rebound as high as 2 percent, but could be as low as 1.5 percent.
  • Okun's Law: The economist Arthur Okun argued that when the unemployment rate falls by 1 percent, gross national product (GNP) rises by 3 percent. The analyst noted the unemployment rate has been "distorted" by the "sharp" drop in the participation in recent years, but "we would expect the unemployment rate to drop by about 0.4 percent for every percentage point that growth outpaces potential."
  • NAIRU: The inflation neutral unemployment rate could be 5 percent, but could "easily" be 0.5 percentage points higher or lower.
  • Phillips Curve: The inverse relationship between rates of unemployment and inflation rates has become "much less sensitive" to the unemployment gap. Prior to 1990, a 1 percentage point unemployment drop would cause a 0.6 percentage point rise inflation. However, the response today may have dropped to 0.2 percentage points or less.
  • Import Price Effect: A 1 percent rise in consumer import inflation adds about 0.2 percentage points to core inflation.

Related Link: Your Federal Reserve ETF Playbook

The Findings

Armed with the raw data and assumptions, the analyst is estimating GDP growth of 3.0 percent in 2016, 2.5 percent in 2017 and 2.0 percent thereafter. Over the same period, consumer import price inflation accelerates from negative 1.3 percent in 2015 to zero next year and plus 1 percent thereafter.

Harris further noted that the unemployment rate could drop to 4.8 percent over the next three years, while core inflation rises to 1.6 percent in 2016 and 1.8 percent in both 2017 and 2018.

By 2018, the inflation rate will approach the Fed's 2 percent target and force the FOMC to "stay on a slow, once per quarter, rate hike cycle."

However, altering the assumptions can also yield some "poor" outcomes. If NAIRU is 5.5 percent, core inflation could hit 2.0 percent in 2017 and 2.1 percent in 2018. In addition, doubling the steepness of the Phillips curve would create "moderate pressure" as inflation rises to 1.9 percent by 2018. Finally, low trend growth would be a bigger concern, and if the trend is 1.5 percent, then inflation will hit 2.1 percent by 2018.

Putting together all three pessimistic assumptions yields a "truly poor scenario" in which unemployment drops to 4.2 percent by 2018, but at the expense of a surging inflation that will hit 3.5 percent in 2018.

Thankfully, the analyst stated this scenario is "very unlikely," although it does mirror a similar episode in the 1960s when the Fed "belatedly" hiked rates, sending inflation rising from 1.3 percent to 3.1 percent in the same year.

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Posted In: Analyst ColorTop StoriesFederal ReserveAnalyst RatingsGeneralEthan HarrisFederal ReserveFedophobiaImport PricesInterest RatesNAIRUOkun's LawPhillips CurveQEUnemployment Rate
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