Central banks play a crucial role in monetary policy and moderating the business cycle. Our Head of Corporate Credit Research explains why, despite their power, these financial institutions can’t quickly steer through choppy economic waters.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about why credit may start to get more concerned that the Fed will make the same mistake it often does.

It's Wednesday, July 3rd at 2pm in London.

Central banks are among the most powerful actors in financial markets, and investors everywhere hang on their every word, and potential next move. If possible, that seemed even more true recently, as central banks first intervened aggressively in bond markets during the height of COVID, and then raised interest rates at the fastest pace in over 40 years.

Indeed, you could even take this a step further: many investors you speak to will argue central banks are the most important force in markets. All else comes second.

But this view of Fed supremacy over the market and economy has an important caveat. For all of their power, the Federal Reserve did not prevent the recession of 1990. It did not prevent the dotcom bust or recession of 2001. It did not prevent the Great Financial Crisis or Great Recession of 2007-2009. These periods have represented the vast majority of credit losses over the last 35 years. And so, for all of the power of central banks, these recessions, and their associated default cycles in credit, have kept happening.

The reasons for this are varied and debatable. But the central issue is that the economy is a bit like a supertanker; it’s hard to turn quickly. You need to make adjustments well in advance, and often well before the signs of danger are clear.

Currently, the Fed is still pressing the economic brakes. Interest rates from the Federal Reserve are well above so-called neutral; that is, where the Fed thinks interest rates neither boost, nor hold back, the economy. The justification for riding the break, so to speak, is that inflation earlier this year has still been higher than expected.

But in the last two months, this inflation has rapidly cooled. Our economists think this trend will accelerate in the second half of the year, and ultimately allow the Fed to cut interest rates in September, November, and December.

Still-high rates and cooling inflation isn’t a problem when the economic data is strong. But more recently, this data has cooled. If that weaker data continues, credit investors may worry that central banks are too focused on the high inflation that’s now behind us, and not focused enough on the potential slowing ahead. They’ll worry that once again, it may be too late to turn the proverbial economic ship.

We’d stress that the risks of this scenario are still low; but late-reacting central banks have – historically, repeatedly – been credit’s biggest vulnerability. It makes it all the more important, that as we head into summer, that the data holds up.

Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today. And for those in the US, a very happy Fourth of July.

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