Slow, steady Fed can lead expansion into year 10

As long as the Fed cautiously pursues the removal of monetary policy accommodation, the U.S. economic expansion, which is currently in its ninth year, is likely to persist. The Fed has raised interest rates only four times since December 2015 and only by a cumulative 100 basis points (bps).

At the same time, the real fed funds rate, defined as the difference between fed funds and the year-over-year change in core inflation, is still negative.

{mosads}Because monetary policy remains extremely accommodative, which is supportive of real GDP growth and financial asset prices, there is a high probability that the current business cycle will last a good deal longer. In turn, equity prices should continue to trend higher.

However, financial market participants should worry about the economic and financial outlook if monetary policy becomes significantly more restrictive. It is a risk given the possible shift in Fed leadership and the numerous vacancies on the Federal Open Market Committee (FOMC) that need to be filled.

In other words, the composition of the Fed matters, and a more hawkish approach to policymaking would be a concern. Fortunately, history offers us a guide, as recessions occur only after the fed funds rate has noticeably risen and at the same time, inflation-adjusted interest rates are well above zero.

How does today’s interest rate hiking cycle compare to the past? In the eight recessions since 1960, the cumulative rise in the fed funds rate during the ensuing business cycle was substantial.

Additionally, at the onset of recession, the real or inflation-adjusted fed funds rate was well above 100 bps. Fortunately, neither of these two situations is present today. The Fed has not done much hiking, and real rates are negative.

When the economy went into recession in 1960, the Fed had increased interest rates by 325 basis points over the previous two years, and the real fed funds rate was 219 bps. The backdrop was even starker before the onset of the 1970, 1974, 1980 and 1981 recessions.

Here’s how a rising federal funds rate might impact other short- and long-term interest rates https://t.co/7mI474QWph pic.twitter.com/3wxj8HaUzX

— St. Louis Fed (@stlouisfed) October 10, 2017

The Fed increased interest rates by roughly 800, 750, 900 and 1000 bps, respectively, in the years immediately preceding these economic downturns. The net effect of these actions was a high real fed funds rate.

For example, the real fed funds rate was nearly 3 percent at the start of the 1970 recession and went above 6 percent at the time of the 1981 downturn. This is the highest ever reading on the real fed funds rate, but it was necessary at the time to break inflation psychology, which eventually it did. The inflation rate, which was near 12 percent at the time, has trended significantly lower ever since.

During the last three business cycles, from 1990 onward, the cumulative increase in the fed funds rate has averaged nearly 400 bps. While the peak in the fed funds rate was not as high in any of these three cycles compared to past, it was still much higher than it is today.

The real fed funds rate was 2.65 percent at the onset of the 1990, 2.14 percent at the beginning of the 2001 downturn and about 1.50 percent at the start of the 2008 recession.

If the Fed raises rates in December, which is widely expected, it would bring the cumulative increase in interest rates to just 125 bps and produce a real fed funds rate that is still negative at around minus 50 bps. This is hardly restrictive policy when compared to history.

The upshot is that as long as the Fed continues to tighten policy at only a gradual pace, the economic expansion can continue for a good deal longer.

Joseph LaVorgna is Natixis’ chief economist for the Americas. Natixis is the international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the second-largest banking group in France. LaVorgna is a frequent contributor to CNBC.