It all depends on your definition of “shock”, now doesn’t it?
That’s my takeaway from a new note out from Goldman that seeks to quantify the effects of a 150bp “unexpected increase” in the Fed funds rate on financial conditions and thereby on the economy.
This builds on a slew of notes the bank has released over the past year that delve into the interplay of Fed hikes, financial conditions and GDP growth.
The bank’s Sunday analysis actually seeks to describe the entire loop between monetary policy, financial conditions and the real economy and it’s an admirable effort as far as these things go.
As noted above, this all depends on how you define “shock” and “unexpected.” Goldman writes that “since anticipated funds rate hikes are typically already priced in bond, stock, and currency markets, they have much smaller effects on financial conditions and growth than unexpected shocks.”
That’s true, conceptually, but it’s important to remember that part and parcel of the post-crises monetary policy regime is ensuring that no tightening of any kind is “unexpected”. The constant two-way communication between the Fed and markets means markets are consulted every step of the way on the appropriate course of policy and in that context, the idea of a “shock” has no meaning.
Implicit in that is the idea that if we were to revert to a hypothetical state of affairs wherein the Fed actually did press ahead against the market’s expectations, the fallout would be dramatic as transparency is withdrawn.
“We estimate that a 150bp hawkish funds rate shock typically tightens the FCI by 100bp”, Goldman writes, before breaking that down by component where 10-year yields leap by 45bp, stocks sell off to the tune of 9% and the dollar appreciates by 4%.
The read-through for the broader economy of a 100bp tightening of financial conditions is, as it turns out, a 1pp hit to GDP after four quarters.
Goldman goes on to revisit the link between GDP growth and unemployment before turning to how the unemployment rate influences wage growth and consumer prices. Finally, they “close the loop” (as it were), by translating labor market slack and inflation into Fed policy.
Along the way, the bank fleshes out their “rules of thumb” for describing the macro economy and needless to say, those rules come with all manner of caveats.
But, for those interested, Goldman made the following aesthetically pleasing flow chart that attempts to summarize the endeavor.
Ultimately, the headline talking points from the bank’s analysis revolve around the estimates shown in the bar chart for what happens across assets in the event of a 150bp “shock” in the funds rate.
I’m not sure if maybe Goldman is trying to send a subtle message to the Fed with this or not, but it’s worth noting that if the Fed does what Goldman’s economics team expects and hikes in December and also in every quarter of 2019, that would be 125bp worth of further hikes against market pricing of, well, much less than that.
In other words, as things stand right now, anything beyond a December hike + one more next year is going to count as a “shock”, so I suppose you can use the above to extrapolate what various assets might do in the event the market continues to doubt the Fed’s resolve only to see Jerome Powell stick to the dots (or more).