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US growth without touching the monetary brake: implications and risks


Historically, the mature phase of US business cycles have been characterised by rising and high real policy rates. This influenced financial markets and acted as a drag on growth. In the current cycle, real rates peaked at a low level and have since declined, following the rate cuts by the Federal Reserve.

TRANSCRIPT // US growth without touching the monetary brake: implications and risks : December 2019



François Doux: US growth and monetary tightening: that’s the subject of this Chart of the Month. William de Vijlder, hello.


William De Vijlder: Hello François.


François Doux: On this chart, real interest rates in the USA show us the degree of restriction on monetary policy and the recession periods. What is the correlation between the two?


William De Vijlder: So, as we look back in time we can see all these recessions. Typically, we see very sharp increases in the Federal Reserve’s real interest rates which have then put a brake on economic growth. We might be tempted to conclude that this has triggered a recession.


François Doux: So what is the problem today?


William De Vijlder: It is very different. The environment today is completely different to what we have seen in the past. First, you will see that there is no grey bar, so we can relax, there is no recession.

We can clearly see that real interest rates have risen because they were very negative. Nominal rates were very low, so after we subtract inflation the result is very negative. So, there was an increase, real rates returned to zero, but then slipped back again.

Why? Because the period of monetary tightening was very short, and the Federal Reserve decided to cut its rates again, given that inflation remained entirely under control and the central bank was concerned about growth trends.


François Doux: So turning to real interest rates as a predictor of recession, the correlation is not really working, for the time being at least. This is particularly because rates are low, so if further cuts were needed, there would be less room for manoeuvre than in the past.


William De Vijlder: There are two ways of looking at this. First, we could say, “there is nothing to worry about, monetary policy will not trigger a recession”. This is a very important factor, notably for the financial markets which, in the past such as in this phase, or in this one, faced a more turbulent period of monetary policy, which affected the willingness to take risks. Today, as there is not this monetary turbulence, the appetite for risk is likely to remain strong.

However, there will come a moment when growth will falter, will not be strong enough, which could cause the appetite for risk to collapse. The problem that will then arise is that, with rates already very low, the scope to cut them further is extremely limited; this clearly opens the way to so-called ‘non-conventional’ policies.


François Doux:  So to sum up William de Vijlder, watch out for a sudden stop?


William De Vijlder: Yes. This is a concept that can be applied in this context. To a degree, it has been imported from the theory of capital movements where we sometimes observe a sudden stop in capital flows towards a given country.

Here, I would say that the risk of a sudden stop is that investors, who, with no monetary constraint, have continued to accept risk will say to themselves, “growth over the next few quarters will leave a lot to be desired, so it is time to take profits”. This could be a sudden shift, even though we have not yet seen it. It is something we will need to be vigilant about.


François Doux: Keep an eye on the Fed.

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