"So we have to make a distinction. If the Fed launches a fresh policy of extraordinary easing in the next downturn, the appropriate response will depend on whether market internals indicate that investors are inclined toward speculation, or whether they are inclined toward risk aversion. The central consideration here is what I call ‘uniformity’ – when investors are inclined to speculate, they tend to be indiscriminate about it. It’s difficult to get extended market advances without recruiting that kind of uniformity, but it will be important to avoid being sucked into the market in response to Fed easing alone. Historically, initial Fed rate cuts in response to a market downturn have been followed by very negative consequences (after the initial obligatory market pop), because they generally indicate that something has gone wrong."

– John P. Hussman, Ph.D., November 28, 2018

Last week, the Federal Reserve issued policy statements intended to telegraph a shift toward easier, or at least more patient monetary policy. Though Wall Street interpreted this shift as a major about-face in the Fed’s policy stance, the most significant shift in Fed Chair Jerome Powell’s statements actually occurred on November 28. Even here, we would characterize the Fed’s policy stance as neutral with a slight hiking bias, but investors should not imagine that a shift to outright easing by the Fed would necessarily be favorable for stocks.

Back on October 3, Powell alarmed investors, I suspect inadvertently, when he communicated the Fed’s efforts to normalize interest rates using these words:

“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore. Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point.”

Powell walked that statement back on November 28, when he described the position of rates as “just below” neutral. Following an additional rate hike by the Fed in December, Powell noted on December 20 that “We have reached the bottom end of the range of committee estimates of what might be neutral. I think from this point forward, we are going to let the data speak to us and inform the outlook.”

That “bottom of the range” view strongly aligns with our own. It’s important to recognize that what we call “structural” real GDP growth (labor force growth + trend productivity) has declined persistently in recent decades, to a level that’s now down to just 1.4% annually. All additional real GDP growth in recent years has been driven by a decline in the rate of unemployment from 10% in 2009 to the current level of just 4%. With a far smaller reservoir of “cyclical” economic slack, it’s likely that real GDP growth will slow toward that 1.4% structural rate. Any material increase in the unemployment rate would go hand-in-hand with a recession, and an outright contraction in real GDP.

As I noted in my November comment, during the relatively low-inflation period since the 1980’s, Treasury bill yields have typically stood 0.5% to 1% above real GDP growth, but slightly below nominal GDP growth. Even if one assumes that stronger productivity will push structural real GDP growth toward 2% annually, a neutral Treasury bill yield would reasonably fall in the area of 2.5-3.0%. Without a further decline in unemployment, an acceleration in productivity, or higher inflation pressures, 1.4% structural real GDP growth would put our range for “neutral” at just 1.9-2.4%. In either case, as Powell observed, short-term interest rates are already within that pocket.