Source: Deutsche Bank, Bloomberg
December 27 for Friday December 28, 2007
Monetary policy was not particularly tight at any point in this economic cycle.
Generally, recessions begin when the Fed over-tightens monetary policy in an attempt to dampen inflation pressures. While the Fed ultimately lifted interest rates by a substantial 425 bps in the current cycle, this was from record low levels. Real interest rates arguably never went into restrictive territory, and since the Fed was so quick to cut interest rates (-100 bps in the last three months) the probability of recession decreases substantially.
In the current cycle, the real fed funds rate, defined as the level of the nominal fed funds rate minus the year-over-year change in the core CPI, peaked at 3.0% in June 2007. In the 2001 recession, the real fed funds rate peaked at 4.0%; and in the recession before that, 1990-1991, it peaked at 5.3%. The average real fed funds rate at the start of a recession is 5.0%, which is 200 bps above where the fed funds rate peaked in the current cycle. A lower peak in real fed funds combined with aggressive easing since then should eventually help steady the financial markets and economy.
We expect another 50 bps in rate cuts as an insurance move to assure a second half 2008 acceleration. We project the unemployment rate to edge up slightly in the next few months and
headline inflation to decelerate as energy prices stabilize/decline in response to slower growth--accordingly, inflation expectations should drift lower.
If economic growth was accelerating significantly, we would be more worried about inflation. However, the reacceleration should be modest at best, since most of the pick-up in domestic demand will likely be back-loaded into H2 2008.
After all, the traditional channel through which lower interest rates lift growth, namely housing, is a channel that is likely to be of limited use in the near term since the housing sector continues to work through a massive supply imbalance which may be relatively immune to lower interest rates.
Consequently, the possibility of a longer and more extended period of declining home prices
cannot be ruled out and with that increased downside growth risks.