Economic Theory

It is too early to know whether the drop in bond yields will offset the drag on growth from tighter lending standards. But if it does, the net effect on equity valuations could be positive. This is enough to justify a modest tactical overweight to equities, with the proviso that investors should look to reduce equity exposure later this year in advance of a mild recession in 2024.

Highlights The possibility that the Fed could cut interest rates later this year if inflation falls more than they expect has caused a renewed focus by market participants on the Fed’s neutral rate views. Owing to its low neutral rate estimate, we can envision a scenario in which inflation decelerates enough to make the Fed feel comfortable easing monetary policy from current levels to a point that it believes is still tight. It is very likely true that the US neutral rate of interest fell for a time following the global financial crisis, but this decline was not likely permanent. A lower neutral rate was caused by US household deleveraging, which ended in the middle of the last economic expansion. The normalization of the neutral rate during the last expansion was not evident to the Fed and many investors, because it was masked by a truly exogenous shock to inflation expectations during the 2014-2016 period. As a result, the Fed never revised its low neutral rate view prior to the pandemic, and currently views the existing stance of monetary policy as extremely restrictive. Any meaningful indications that the Fed is likely to cut the fed funds rate before a recession has begun would have a significant impact on our recommended cyclical investment strategy. We would very likely recommend raising exposure to risky assets in this scenario. For now, this remains a possible but not probable outcome. Over the longer run, however, we think this scenario would risk quite a negative outcome for both equity and fixed-income investors. If the Fed inadvertently moves monetary policy back into stimulative territory over the coming months, it would significantly increase the chances of elevated structural inflation. That would likely be devastating for both equity and bond prices, as sharply higher rates cause a severe contraction in economic activity. Feature Over the past month, there has been a renewed focus by market participants on the Fed’s low neutral rate views. Federal Reserve Chair Jerome Powell seemingly opened the door to the possibility that the Fed would cut interest rates if inflation falls further than they expect over the coming year, potentially even if the unemployment rate has not increased meaningfully. The idea that the Fed could move short-term interest rates lower, even if growth is stable and reaccelerating, emerges primarily from their view of a very low neutral rate of interest. While the neutral rate is a technical or arcane concept for many investors, it is extremely important because it determines whether any given interest rate level is stimulative or restrictive. It has been the long-stated view of several BCA Research services that the US neutral rate is meaningfully higher than the Fed and many investors believe. Table II-1 presents a (non-exhaustive) list of BCA Research reports dating back to at least 2019, when we presented this perspective. Table II-1BCA Has Long Argued That The Neutral Rate Is Higher Than The Fed And Investors Believe March 2023 March 2023 In this report, we consider renewed investor interest in the question of the neutral rate as a welcome opportunity to revisit what has been a core BCA view for some time. We review the theoretical determinants of the neutral rate of interest, and compare the empirical record to what theory would predict. We also discuss why the “new neutral” narrative emerged during the last economic cycle, and why we believe that a decline in neutral rate – that did likely occur in the years following the global financial crisis – was temporary. We conclude by underscoring that the Fed’s low neutral rate view could create the basis for pro-risk positioning over the coming year, but that this scenario is not yet likely and would also create meaningful longer-term risks for investors. As such, we continue to recommend that investors position conservatively over the coming 6-12 months. The Theoretical Determinants Of The Neutral Rate Of Interest The idea of the neutral rate of interest, originally termed the “natural” rate of interest, originated from Knut Wicksell in 1898. Wicksell argued that “there is a certain rate of interest which is [natural/neutral] in respect to [prices], and tends neither to raise nor to lower them.” Since then, the concept of the neutral rate of interest has been expanded to represent the interest rate level that is consistent with the overall economy being in a state of equilibrium, all else being equal. Generally speaking, that means output that is in line with its potential, a balanced labor market, and inflation that is in line with the central bank’s target. While the neutral rate is a technical or arcane concept for many investors and is not directly observable, it certainly exists and is extremely important from an investment strategy perspective. It is clear from several decades of experience that interest rates have a powerful effect on aggregate demand, underscoring that there must be some level at which interest rates cease to stimulate economic activity and begin to restrict it. And from an investment strategy standpoint, the entire basis of monetary policy stabilization efforts hinge on whether monetary policy is stimulative or restrictive at any given interest rate level, underscoring that investors need to have a sense of where that boundary is in order to forecast economic activity and, by extension, corporate profits. From a theoretical, closed-economy perspective, the main determinants of the neutral rate of interest can be derived from the classic Solow Growth Model (see Appendix 1):1 Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand, and faster growth in aggregate income will raise the sustainable level of interest on borrowed funds for both investment and consumption. This will elevate the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will raise the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require considerable physical capital will tend to have a higher neutral rate of interest. By the same token, economies in which the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest. Neutral Rate Theory Versus The Empirical Record The historical evidence shows a somewhat different picture than what theory would suggest, at least in terms of justifying the Fed’s very low neutral rate view. Chart II-1Trend GDP Growth Closely Correlates With Bond Yields Trend GDP Growth Closely Correlates With Bond Yields Trend GDP Growth Closely Correlates With Bond Yields Let’s first address trend GDP growth as a determinant of the neutral rate of interest. We entirely agree with this framework, and believe that trend growth is by far the dominant driver of the neutral rate. Chart II-1 highlights that 10-year government bond yields have been closely linked to trend rates of growth over the past six decades. Deviations in this relationship have occurred in the past, but, until the 2008-2009 global financial crisis, they were explained by the lagged difference in inflation from 2%. That means that prior to 2008, the fact that interest rates were above or below trend growth mostly reflected Fed decision-making, rather than structural factors. On the second question of higher/lower national savings and its impact on the neutral rate of interest, we agree that cyclical changes in the savings/investment balance likely have an impact on interest rates, because they will be strongly linked to fluctuations in economic activity and the output/jobs gap. But as we discussed in our April 2022 Special Report,2 we don’t really see much evidence of a lasting structural savings/investment effect on the neutral rate beyond a brief period in the 2000s. Chart II-2 makes this point using a globally comparable savings measure: gross national savings, calculated as gross national income less total consumption, plus net transfers. In the US, the chart shows that gross savings have been trending down over time, even prior to the global financial crisis, underscoring that the neutral rate of interest should have moved up according to the Solow growth model (holding all else constant). Globally, it is true that gross savings rose significantly from the early-2000s until the global financial crisis, a phenomenon that has been referred to as the “global savings glut” – which occurred mainly because of China’s massive current account surplus. We do find evidence that the global savings glut reduced long-maturity US Treasury yields during this period, but it was a temporary effect that, on its own, caused only a modest gap between interest rates and trend growth. Chart II-3 shows that all three of our estimates for the 10-year Treasury term premium fell during this period, which did prevent long-maturity yields from rising as the Fed raised interest rates and probably did contribute to a relatively early inversion of the US yield curve in 2006. Chart II-2US Gross National Savings Have Trended Lower Over Time US Gross National Savings Have Trended Lower Over Time US Gross National Savings Have Trended Lower Over Time Chart II-3The Global Savings Glut Did Lower Bond Yields Somewhat In The 2000s... The Global Savings Glut Did Lower Bond Yields Somewhat In The 2000s... The Global Savings Glut Did Lower Bond Yields Somewhat In The 2000s... But Chart II-4 highlights that Fed policy also greatly contributed to low bond yields during this period, given that the Fed cut the funds rate aggressively during the 2001 recession and kept it there for close to three years. On the one hand, typical monetary policy rules supported the idea that the Fed should have been slower to raise interest rates. On the other hand, even the more dovish versions of the Taylor rule show that the Fed cut too deeply, which significantly depressed 5-year Treasury yields and helped inflate the housing bubble that ultimately caused the subprime and global financial crises. On the third question of capital intensity, based on several measures of intensity, there is little basis to believe the neutral rate has permanently declined in the US. Chart II-5 shows that there has been no structural downtrend in total US investment (private plus government) as a share of GDP and that this measure today is not far from its post-war median. Chart II-6 makes the same point from the perspective of the incremental-capital-to-output ratio (ICOR), which accounts for depreciation, and shows that there has been no structural uptrend in the ICOR regardless of what measure of the real capital stock is used. Chart II-4...But So Did Too-Easy Fed Policy! ...But So Did Too-Easy Fed Policy! ...But So Did Too-Easy Fed Policy! Chart II-5No Structural Downtrend In US Investment As A Share Of GDP No Structural Downtrend In US Investment As A Share Of GDP No Structural Downtrend In US Investment As A Share Of GDP Chart II-7 shows that capital-intensive investment (equipment and structures) has fallen as a share of total investment. It is conceivable that this is leading to a lower neutral rate of interest. But this has corresponded with an increase in the depreciation rate, which theoretically supports a higher neutral rate. More importantly, this decline in capital-intensive investment has been occurring for decades, and interest rates did not fall meaningfully below the prevailing or potential rate of economic growth until the mid-2000s, and not persistently so until after 2008. Chart II-6No Uptrend In The US ICOR No Uptrend In The US ICOR No Uptrend In The US ICOR Chart II-7Capital-Intensive Investment Has Fallen As A Share Of Total, But This Is Not A New Trend Capital-Intensive Investment Has Fallen As A Share Of Total, But This Is Not A New Trend Capital-Intensive Investment Has Fallen As A Share Of Total, But This Is Not A New Trend Some Additional Points On The Empirical Record Two other points are worth noting with respect to evidence in favor of or against a permanently lower neutral rate of interest. The first relates to the 2018-2019 period, one that many investors have pointed toward as evidence that the neutral rate is indeed meaningfully lower then trend rates of economic growth. The crux of this argument is that interest rates crossed into tight territory according to common academic estimates of the neutral rate of interest (Chart II-8), and that the US economy slowed meaningfully in response. The US yield curve inverted, and the Fed was forced to cut interest rates by 75 basis points in order to stabilize growth, which is exactly what one would expect to see if interest rates had ceased to become stimulative. As a first point, we have highlighted in previous research that econometric estimates of the real neutral rate of interest, such as those calculated by the (now discontinued) Laubach-Williams (L&W) model, are almost certainly wrong.3 Many econometric approaches to determining the neutral rate of interest rely on the simultaneous specification of other variables such as the output gap. These values can be used to determine whether the model as a whole is producing sensible results. As of the last available update to the L&W model, the US output gap turned positive in Q1 2012 (Chart II-9), while the US unemployment rate was 8.3%. That is a plainly wrong result, and underscores that the L&W model is unreliable, because the output gap is a central element of the model’s estimate of the neutral rate. Other neutral rate estimates, such as those derived from the New York Fed DSGE Model, offer confidence ranges so wide that they render the estimates themselves useless. At an 80% confidence range, the New York Fed’s model suggests that the real neutral rate was between -9.4% and 30.5% as of December 2020. Today, the model suggests that the real neutral rate is somewhere between 1.2%-4%. That is not particularly helpful for investors. Chart II-8Was The 2018-2019 Episode Evidence Of A Low Neutral Rate? The Answer Is No. Was The 2018-2019 Episode Evidence Of A Low Neutral Rate? The Answer Is No. Was The 2018-2019 Episode Evidence Of A Low Neutral Rate? The Answer Is No. Chart II-9Was The Output Gap Closed In 2012 At An 8.3% Unemployment Rate? It Was Not. Was The Output Gap Closed In 2012 At An 8.3% Unemployment Rate? It Was Not. Was The Output Gap Closed In 2012 At An 8.3% Unemployment Rate? It Was Not.   In addition, as we noted in our April 2022 Special Report, the idea that the 2018-2019 episode supports a very low neutral rate view entirely ignores the fact that the US and global economies were negatively impacted by a politically-driven nonmonetary shock to aggregate demand during this period: the China-US trade war, which also impacted or targeted several major advanced economies. Chart II-10 highlights that global trade uncertainty exploded during this period, which severely damaged business confidence around the world and caused a slowdown in global industrial production. Tighter Chinese policy also likely contributed to the slowdown in global activity, but the bottom line is that factors other than US monetary policy contributed to economic weakness during this period. It is therefore incorrect to infer from the 2018-2019 experience that interest rates rose to or exceeded the neutral rate of interest. The other empirical point worth noting is the important information conveyed by the National Federation of Independent Business (NFIB) survey about the stance of monetary policy. While the NFIB includes firms that are not particularly capital intensive in its surveys – the typical member employs ten people and reports gross sales of about $500,000 a year – the details of the survey can help investors triangulate whether monetary policy is easy or restrictive. Chart II-11 illustrates the short-term interest rate paid by small businesses, alongside the percent of NFIB survey respondents reporting demand and interest rates & finance as the single most important problem facing their businesses. The share of businesses quoting interest rates & finance as their most pressing problem has historically been small given that sales and compensation costs are usually the dominant drivers of firm profitability, but the series shown in Chart II-11 allow point-to-point comparisons vis-à-vis interest rates and contextualizes those answers through the lens of rising or falling demand. Chart II-10The US Economy Slowed In 2018-2019 Because Of A Massive Trade Shock, Not Because Of interest Rates The US Economy Slowed In 2018-2019 Because Of A Massive Trade Shock, Not Because Of interest Rates The US Economy Slowed In 2018-2019 Because Of A Massive Trade Shock, Not Because Of interest Rates Chart II-11The NFIB Survey Shows That Interest Rates In 2018-2019 Were Not Restrictive The NFIB Survey Shows That Interest Rates In 2018-2019 Were Not Restrictive The NFIB Survey Shows That Interest Rates In 2018-2019 Were Not Restrictive   What is particularly important about Chart II-11 is where the series in panel 2 was toward the end of 2018 / early 2019, just before the Fed began to cut rates in response to the Trump trade war. While the number of firms reporting rates/finance as their most important problem was rising at that time, it was no different than it was in 2005/2006 when the small business loan interest rate was at roughly the same level. This is in sharp contrast to the much higher number of firms reporting rates/finance as their top problem in the face of lower interest rates in the early aftermath of the global financial crisis. This suggests that the neutral rate of interest did fall in the early years of the last economic recovery, but also that it had normalized by the time that the COVID-19 pandemic began. The conclusion for investors is that, while it is very likely true that the US neutral rate of interest fell for a time following the global financial crisis, this decline was not likely permanent – in striking contrast to the Fed’s views about the neutral rate and the “new neutral” market narrative. In the latter half of the last economic cycle, the neutral rate of interest was either equal or very close to trend rates of economic growth. The New Neutral Rate Narrative The idea that the neutral rate of interest has fallen well below the trend rate of economic growth did not emerge spontaneously. It occurred in response to the fact that growth and inflation during the last economic cycle was very weak relative to historical norms, despite the fact that the Fed kept short-term interest rates pinned to the zero lower bound for seven years. We agree with the perspective that, first, the neutral rate of interest fell for some time following the global financial crisis, and that, second, it occurred because of a savings/investment imbalance. But this imbalance was cyclical in nature rather than structural, in the sense that it was caused by the events leading up to and following the subprime and global financial crises – not exogenous shifts in savings preferences. And it proved to be a temporary decline, not a permanent shift, as some investors and the Fed came to believe. Chart II-12 highlights the clear source of excess savings for several years following the global financial crisis. The housing and debt-focused nature of the 2008-2009 Great Recession caused a multi-year period of US household deleveraging, which actually saw the outstanding level of household mortgage debt fall (something that had never occurred in the post-war era). Combined with a significant tightening in credit availability because of the balance sheet conditions of US banks and newly-instituted regulations, total household credit growth fell well below the growth rate of disposable income despite rock-bottom interest rates (panel 2). This period of deleveraging almost exactly matches the period over which the US economy had a negative output/jobs gap, underscoring that this excess savings period was cyclical rather than structural in nature and occurred because of the balance sheet effects of the great recession. Chart II-12The Neutral Rate Fell Because Of US Household Deleveraging, Which Is Over The Neutral Rate Fell Because Of US Household Deleveraging, Which Is Over The Neutral Rate Fell Because Of US Household Deleveraging, Which Is Over Chart II-13Growth Was Historically Weak Last Cycle, But Only Because Of The First Few Years Of The Expansion March 2023 March 2023     As Chart II-12 highlights, this active deleveraging process ended around 2015, roughly in the middle of the expansion. Chart II-13 highlights that the very weak growth of the last expansion occurred entirely while US consumer deleveraging was underway. The chart shows that real per capita growth in the latter half of the last economic expansion was not meaningfully different compared to previous economic recoveries, despite the fact that this is when interest rates were normalizing and when several major nonmonetary shocks to US and global growth occurred, such as the oil-driven CAPEX recession of 2014-2016 and the Trump administration’s trade war with China and several DM countries in between 2018 and 2019. From Weak Growth To Weak Inflation Chart II-14US Inflation Remained Below Target Even After US Household Deleveraging Ended US Inflation Remained Below Target Even After US Household Deleveraging Ended US Inflation Remained Below Target Even After US Household Deleveraging Ended The events between 2014 and 2016 were also a very important determinant of why the Fed and many investors believed that the neutral rate permanently declined – even though economic growth meaningfully improved in the latter half of the last economic cycle. We noted above that the concept of the neutral rate of interest has been generalized to represent the interest rate level that is consistent with the overall economy being in a state of equilibrium, including for inflation (with equilibrium defined as the central bank’s target). The fact that core PCE inflation remained below the Fed’s 2% target for essentially the entire period of the last expansion acted as strong evidence for many, including the Fed, that interest rates were likely to remain permanently low (Chart II-14). As we discussed in detail in our January 2021 Special Report,4 inflation is only consistent with a central bank’s target if 1) inflation expectations are in line with that target and 2) there are no cyclical effects pushing inflation higher or lower. These cyclical effects are typically driven by the output/jobs gap, but supply shocks, even for core inflation, can push inflation away from its equilibrium level for some time. Chart II-15Massive And Unexpected US Shale Production Caused A Huge Shock To Oil Prices Massive And Unexpected US Shale Production Caused A Huge Shock To Oil Prices Massive And Unexpected US Shale Production Caused A Huge Shock To Oil Prices Inflation expectations remained stable for four-to-five years following the global financial crisis, which is surprising given the size of the jobs gap during this period. We believe that expectations stayed very well anchored during this period because of the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. While inflation expectations did not decline during this weak growth period, the long-lasting weakness in demand from household deleveraging left expectations vulnerable to exogenous shocks. In 2014, such a shock emerged: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-15), which even surprised energy sector experts and resulted in a substantial and long-lasting imbalance in the global oil market. We view this event as a genuinely exogenous shock to prices, given that research and development of shale technology had been ongoing since the late 1970s and only happened finally to gain traction around 2010. Chart II-16 shows that the 2014 oil price collapse caused a clear break lower in our adaptive inflation expectation measure, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-17). Chart II-16A Collapse In Oil Prices Collapsed Our (Already Vulnerable) Measure Of Inflation Expectations... A Collapse In Oil Prices Collapsed Our (Already Vulnerable) Measure Of Inflation Expectations... A Collapse In Oil Prices Collapsed Our (Already Vulnerable) Measure Of Inflation Expectations... Chart II-17...As Well As Long-Term Market And Household Inflation Expectations ...As Well As Long-Term Market And Household Inflation Expectations ...As Well As Long-Term Market And Household Inflation Expectations This disinflationary shock to inflation expectations explains why actual core inflation was below the Fed’s target in the latter half of the last economic expansion when growth was on par with that of previous expansions and the output/jobs gap was nearly closed. Strangely, the Fed and many investors did not seem to recognize this effect, and instead saw the ongoing weak inflation during this period as supporting the idea of a permanently low neutral rate. The key point for investors is that while the neutral rate did decline during the last economic cycle, it was a temporary phenomenon for which normalization was masked by an exogenous shock to inflation expectations. As a result, the Fed never revised its low neutral rate view prior to the pandemic, and currently views the existing stance of monetary policy as extremely restrictive in order to bring inflation rapidly back to its 2% target. The Neutral Rate Today, The Fed, And The Current Economic Outlook Chart II-18No Savings/Investment Basis To Believe Neutral Is Different Than Trend Growth No Savings/Investment Basis To Believe Neutral Is Different Than Trend Growth No Savings/Investment Basis To Believe Neutral Is Different Than Trend Growth Based on our analysis presented above, we do not currently believe that the US nominal neutral rate of interest is meaningfully above or below the current trend rate of economic growth. Based on the CBO’s estimate of real potential GDP growth (1.8%) plus the Fed’s inflation target of 2%, that implies that the current nominal neutral rate is just under 4%. However, we note that CBO’s nominal potential GDP growth projections, as well as actual GDP growth over the past decade, would imply an even higher nominal rate. We discussed above that a savings/investment imbalance can exert cyclical effects on interest rates. Many BCA Research services have noted the existence of excess household savings that have accrued during the pandemic. Some investors have been puzzled by how to balance this observation against the fact that interest rates have risen at their fastest pace in four decades, to a level above our estimate of neutral, without the US having slipped into recession. When considering this question, it is important to note that it is national savings that matter when considering the savings/investment balance. Chart II-18 highlights that the US government massively dissaved during the pandemic. Panel 2 of Chart II-18 shows that the US private sector financial balance, defined as the difference between gross private savings and gross private domestic investment, surged during the pandemic but has since fallen well below the average level seen during the last economic expansion. From our perspective, this underscores that there is no savings/investment basis to argue that the neutral rate is meaningfully different than that of trend growth. However, based on the FOMC’s summary of economic projections, the Fed does not share this view. Chart II-19 highlights that the highest Fed estimate of the funds rate over the longer run is 3.3%, well below that of trend economic growth. The chart also highlights that investors have recently raised their estimate of the neutral rate, but it is still below prevailing estimates of potential growth. Chart II-19The Fed Still Believes In The New Neutral Narrative, Which Could Have Very Important Implications For Monetary Policy As Inflation Falls The Fed Still Believes In The New Neutral Narrative, Which Could Have Very Important Implications For Monetary Policy As Inflation Falls The Fed Still Believes In The New Neutral Narrative, Which Could Have Very Important Implications For Monetary Policy As Inflation Falls Our neutral rate view will likely have important implications for long-maturity government bond yields in the aftermath of the next US recession. But over the coming year, the more important question for investors is whether the Fed’s low neutral rate view will act as a basis for the Fed to cut interest rates back to what we would consider to be stimulative levels before a recession has begun. As we have noted in several recent reports, US monetary policy is now tight, even based on our view of the neutral rate of interest; and it is on this basis that we have been recommending that investors position their portfolios conservatively over the coming year. As we discussed in our February 2023 Special Report,5 we can envision a scenario in which inflation decelerates enough to make the Fed feel comfortable easing monetary policy from current levels, but to a point that is still tight according to its estimate of the neutral rate of interest. Table II-2 highlights that a monetary policy rule that has been cited by Fed officials and by researchers would prescribe what we would consider to be easy monetary policy if core PCE inflation were to fall below 2.9%, which is (for now) in line with its current three-month annualized rate of change. Table II-2A Dovish Taylor Rule Would Prescribe Sub-4% Policy Rates If Core PCE Inflation Is Below 3% March 2023 March 2023 Chart II-20The Real Short-Term Interest Rate Is Already Positive Based On Recent Core Inflation The Real Short-Term Interest Rate Is Already Positive Based On Recent Core Inflation The Real Short-Term Interest Rate Is Already Positive Based On Recent Core Inflation This truly cannot be ruled out as a possible outcome, because the basis for the Fed’s elevated interest rate forecast relative to what monetary policy rules would prescribe may prove to be ephemeral. The Fed may believe that the neutral rate of interest is temporarily higher, a perspective that could quickly change as inflation slows further and the labor market weakens. Or it may be using simpler perspectives, such as the idea that the real fed funds rate should be positive to return inflation back toward its target, which has already occurred based on shorter-term measures of inflation (Chart II-20). Any meaningful indications that the Fed is likely to cut the fed funds rate before a recession has begun would have a significant impact on our recommended cyclical investment strategy. We would very likely recommend raising exposure to risky assets in this scenario. We discussed this possibility in our February report and concluded this is not yet a likely scenario, but we will continue to monitor the odds of this potential event throughout the year. Over the longer run, however, we think this scenario would risk quite a negative outcome for both equity and fixed-income investors. A scenario in which the Fed inadvertently moves monetary policy back into stimulative territory would substantially raise the odds that long-term inflation expectations would cease to become well-anchored unless they had fallen from current levels by that point: that is, it would significantly increase the chances of elevated structural inflation. This is what Martin Barnes, BCA’s former Chief Economist, outlined in our July 2022 Special Report.5 Structurally higher inflation would obviously be negative for investors with long-maturity government bond positions; we suspect that it would also be negative for profit margins (as it was during the late-1960s and 1970s) and would imply higher risk premia for both stocks and bonds. Investment Conclusions It is the view of the Bank Credit Analyst service that the Fed’s very low neutral rate is folly rather than fact, which results in a complicated investment reality. Over the coming 6-12 months, it raises the odds that the Fed will unknowingly return monetary policy to stimulative territory in response to a significant further easing in inflation, even if inflation has not yet returned to the Fed’s 2% target and the unemployment rate has not risen significantly. If this were to occur before a US recession has begun, it would extend the economic cycle, and would validate expectations of positive earnings growth over the coming year. It would also result in higher equity multiples in response to the combination of lower long-maturity bond yields and a likely decline in the equity risk premium. Under these circumstances, pro-risk positioning, at least for a time, would be clearly warranted. However, this scenario would also significantly raise the risk of unmoored long-term inflation expectations, which would mean that inflation would likely come in persistently above the Fed’s target without a materially higher fed funds rate and a meaningful period of the unemployment rate above NAIRU. This scenario implies that the next US recession would be more severe than we currently expect, and would likely be devastating for both equity and bond prices. Until we see clear signs that the Fed is likely to bring monetary policy back into easy territory outside of the context of a recession, our neutral rate views, in conjunction with the current level of the fed funds rate, argues for a conservative investment stance over the coming 6-12 months. As noted, we remain attuned to the possibility that the Fed will significantly reduce interest rates on the basis of its very low neutral rate view, but the odds of this outcome are low and have recently fallen. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst APPENDIX 1 Solow Growth Model And The Neutral Rate Of Interest March 2023 March 2023 Footnotes 1     Please see Global Investment Strategy "Are High Debt Levels Deflationary Or Inflationary?," dated February 15, 2019, available at gis.bcaresearch.com 2    Please see The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com 3    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 4    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "What Will It Take For The Fed To Cut Rates?" dated January 26, 2022, available at bca.bcaresearch.com 6     Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com

The risk of a recession in 2023 is being supplanted by the risk of another inflation wave. We will turn more defensive on equities if it continues to look like inflation is making a comeback.

Ironically, increased confidence that the economy can withstand higher bond yields may be necessary to lift yields to a level that is actually detrimental to growth. Thus, until more investors are convinced that a recession will be averted, a recession will be averted. Remain tactically bullish on stocks for now. A more defensive posture will likely be necessary later this year.

The Fed is betting that the usual non-linearity of unemployment is different this time, but so far, there is nothing to suggest that it is different. We discuss the key signposts to watch out for, plus the implications for interest rates and asset allocation.

The US economy will experience a period of benign disinflation over the next few quarters. Beyond this goldilocks period, either the economy will slip into a mild recession in 2024, or more ominously, a second wave of inflation will prompt the Fed to slam on the brakes, leading to a deep recession.

Hopes of a soft landing for the US economy will intensify over the coming months, allowing equities to rally. However, even if an equilibrium of high employment and low inflation is reached, it will be difficult to keep the economy there. Investors should remain tactically bullish on stocks but look to turn defensive in the second half of 2023.

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out next year and beyond.

2023 will be another challenging year for the US equity market, characterized by the Fed’s battle with inflation, slowing economic growth, and earnings contraction. The S&P 500 is likely to reach new lows in the first half of the year falling as much as 20-25%, only to rebound sharply in the second half, once all the bad news is priced in.

In this Special Report, we consider what some common monetary policy rules are recommending for the major central banks and derive conclusions on duration strategy and country allocation for bond investors. We conclude that rate hike expectations in most countries may appear appropriate given the current global backdrop of high inflation and low unemployment, but look elevated on a forward-looking basis versus slowing global growth and peaking global inflation.