The Fed: Tightening Or Merely Normalizing?

This is an excerpt from the Yardeni Research Morning Briefing, December 15, 2023.

Based on November’s employment report released on Friday, we can safely conclude that there is still no sign of an impending recession. The Godot recession is still a no-show. Our soft-landing (a.k.a. rolling recession) scenario remains intact, as it has since early last year. The diehard hard landers are still expecting a recession, as they have been since the Fed started to tighten in early 2022. But they now expect it in 2024 and mostly think that it will be a shallow recession.

The widely anticipated recession scenario has been based on a very simple and logical premise: The Fed started raising interest rates aggressively last year during May. Short-term and long-term rates have increased by at least 500bps through the summer (Fig. 1). That shocking pivot, following a very long period of ultra-easy monetary policy, must be a terrible shock for the economy, the thinking goes. While the “long and variable lags in monetary policy” have turned out to be longer and more variable this time, a recession will surely occur in 2024, the hard landers figure.

Additionally, the hard landers point out: The yield curve has been inverted since the summer of 2022 (Fig. 2). The Index of Leading Economic Indicators has been falling since it peaked at a record high during December 2021 (Fig. 3). The y/y growth rate of real M2 has been negative since May 2022 (Fig. 4). The real federal funds rate has soared from -8.46% during March 2022 to 2.09% during October (Fig. 5). All of them have been mostly accurate leading indicators of recessions in the past.

Yet contrary to this plausible argument, the economy has remained resilient and avoided a recession so far. Here we are in December 2023, and the unemployment rate remains below 4.0%. Full-time employment is at a record high (Fig. 6). So is payroll employment, which is one of the four components of the Index of Coincident Economic indicators (CEI). It is the first to come out every month and suggests that the CEI rose to yet another new record high in November, confounding the LEI’s followers (Fig. 7).

In recent months, we’ve provided several explanations for why the hard landers and their indicators have been wrong so far. (See, for example, “Captain America,” title of our November 8, 2023 Morning Briefing.) Here’s a new one: Perhaps the Fed hasn’t been tightening monetary policy so much as normalizing it. Interest rates are back to the Old Normal. They are back to where they were before the New Abnormal period between the Great Financial Crisis and the Great Virus Crisis, during which the Fed pegged interest rates near zero.

The normalization theory implies that the Fed might not lower interest rates next year as much as widely expected. That’s because the economy wouldn’t require as much easing to reverse the tightening after the tightening has done its job of bringing down inflation. If the economy remains resilient but inflation continues to fall closer to the Fed’s 2.0% target next year—both of which we’re expecting—then the Fed might lower the federal funds rate twice next year, by 25bps each time, instead of four times or more as widely anticipated. After Friday’s employment report, this was less widely anticipated.

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