NN IP: Powell, the winds, and the waves

Last week markets were waiting with bated breath for Jerome Powell’s first press conference as Fed Chair to see if he had any surprises for them. In general, central bankers do not like surprises. In fact, former BoE Governor Mervyn King once said that central bankers want to be boring, by which he meant that they do not want to add unnecessary volatility to the markets and the real economy.

This is a noble intention in theory but sometimes difficult to implement in practice. After they had been driven very far into unconventional territory, Ben Bernanke, Mario Draghi and Haruhiko Kuroda all found out that even the slightest hint that they were contemplating a marginal change to policy could have huge market consequences. The reason is that it is much more difficult for markets to calibrate central bank policy when the banks are using several instruments that have not been used before.

Hence, it is not surprising that the G3 central banks emphasized gradualism and predictability in the past few years. For the Fed this is slowly becoming less important, for the simple reason that the policy rate is now further into positive territory and is widely expected to continue to rise in the foreseeable future. Meanwhile, markets have a substantial degree of certainty about the outlook for the size of the balance sheet because roll-off has been put on auto-pilot.

This does not make Powell’s life or that of his companions much easier. His predecessor, Janet Yellen, was already confronted with a substantial degree of uncertainty. The Fed’s mandate tells it to target price stability and, subject to that, full employment, but no one really knows when the economy will reach that point. There may still be scope for a rise in the prime age participation rate.

A rise in underlying productivity growth may also allow for a higher level of production out of the existing workforce without triggering additional inflation pressure. In fact, inflation has been well below target for a number of years and many would consider it desirable for inflation to rise moderately above target before the next recession hits. This will help to cement on-target inflation expectations and provide an inflation buffer for the next downturn.

A final important issue weighing on Fed decision-making is the fact that overall financial conditions are still a lot easier than they were a year ago despite a number of rate hikes. The Fed has taken its foot a bit off the accelerator but the car has speeded up nevertheless. As a result of all this, the Fed has been in risk management mode for the past year or so. It weighs the risk of overheating in the real economy and/or financial markets against the risk of inflation remaining below target in the foreseeable future.

The Fed will have to navigate several waves

The economic environment that shapes this trade-off has changed considerably over the past six months or so. When Yellen was still Fed Chair, her game plan was more or less to guide the economy on a glide path where growth slows gradually towards potential, the unemployment stabilizes a bit below 4% and inflation gradually converges towards the target. If this plan were successful, the Fed would achieve a kind of equilibrium that could be sustained for some time to come. Of course, markets would like that a lot.

Fast forward six months, and Powell is looking at an economy where the other branch of policymaking (fiscal/trade) is making a lot of waves. These waves greatly diminish the prospect of reaching the Yellen glide path equilibrium and thus make the Fed’s job a lot more difficult. As such the markets are likely to take a less benign view of the outlook at some point and the recent increase in volatility may already be a harbinger of that.

Still, for now the Fed is putting a positive spin on these waves. The short-term effect of two of these waves (US fiscal policy and global growth) is likely to be positive indeed. Hence as long as the other wave (protectionism) remains small, the overall market impact in the near term should remain benign.

The positive spin comes under the guise of the term “headwinds turning into tailwinds” and was stated very eloquently by Fed Governor Lael Brainard in a recent speech. She referred to synchronised and strong global growth momentum, the appreciation of foreign currencies due to non-US growth acceleration, higher commodity prices and the positive impact on EM economies and DM investment spending, easy financial conditions and, last but not least, a substantially positive US fiscal pulse for this year and the next.

All of these developments basically raise the neutral real policy rate (r-star) in the short term. At the same time, the additional demand push embedded in them should help inflation to rise somewhat faster towards the target, because of which less monetary accommodation is needed. The Fed will thus feel more confident in closing the gap between the policy rate and r-star and, on top of that, it will feel the need to shadow r-star higher. This need not be market-negative in the near term. The Fed will push the policy rate further into positive territory but the main drivers here are the aforementioned tailwinds.

Nevertheless, waves and tailwinds die out at some point and sometimes the latter turn into renewed headwinds. On current legislation there will be a fiscal cliff in 2020 the size of which is still unknown, also because Trump may come with more stimulus to improve his re-election chances. How effective such renewed stimulus will be at a point where the unemployment rate is probably below 3.5% and US debt-to-GDP is rising remains to be seen. On top of that, the momentum in global growth and US capex growth could well have abated by then as well.

All these factors will work to reduce the US short-term level of r-star at a point where the actual policy rate is probably already somewhat in restrictive territory. In theory, the Fed could prevent such an endogenous tightening of policy by cutting rates somewhat again, but in practice this may be very difficult. Estimates of r-star are surrounded by uncertainty, so such a move would be extremely hard to calibrate.

What’s more, because the Fed only wants to react to persistent shocks and not to noise, its reaction will probably be a case of too little too late. A possibly sharp endogenous tightening of policy could thus happen in 2020. If it does, it will only serve to increase market volatility which may already exist due to the waning of the waves. It is important to emphasise that none of this is certain at this point. One variable that could save the day is underlying productivity growth. A marked improvement on that front would slow down the pace at which the unemployment rate declines, reduce the NAIRU and increase r-star, all else being equal.

Before we reach this point, we could of course be hit by a strong wave of protectionism, which would complicate the Fed’s job further. In principle, such a wave is stagflationary. In theory the effect on the price level is theoretically a one-off event and in an anchored inflation expectations world, this should not lead to second-round effects. Nonetheless, successive rounds of retaliation could affect the price level for some time.

Meanwhile, disruptions to supply chains and falling business confidence would reduce growth momentum. If all of this happens it will be difficult for the Fed to calibrate a response, especially in the midst of the fiscal sugar high. Our best guess for now is that it would lead to a somewhat slower pace of hikes.

Powell stays calm

Amidst all these possible waves, Powell chose to make as few additional waves of his own during the press conference and was pretty successful in this endeavour. The most eye-catching innovation in the statement was that “the economic outlook has strengthened”, a remark that clearly trumps the observation that consumption and investment spending had moderated somewhat recently. To provide some dovish counterweight, the statement retained the notion that risks are “roughly balanced” and that rates are “likely to remain below levels that are expected to prevail in the long run for some time”.

The latter statement in particular is becoming a bit outdated, while one can justify roughly balanced risks on the back of the threat of protectionism. Also the statement retained the notion that further gradual adjustment to the policy stance will be warranted, which confirms our previous story about closing the gap between the policy rate and r-star and gradually shadowing the latter higher. To be sure, the long-run dot for the policy rate, which is an indication of the long-run estimate of r-star only moved up marginally. We do not see this as inconsistent with our story because short-run r-star can be more volatile due to the aforementioned waves.

The median dot for 2018 remained unchanged at three hikes for the whole year, but only just. It takes only one participant to change his mind to move to a median dot of four. The median dot for 2019 was raised from two to three and in 2020 the median dot is at two, which would take the policy rate some 50 bps into restrictive territory by the end of the year, taking the Fed’s long run r-star estimate as a benchmark. This can be justified by the growth, unemployment and inflation forecast. Growth is expected at 2.7% and 2.4% in 2018 and 2019 respectively, well above the 1.8% potential growth estimate. As a result, the unemployment rate is expected to trough at 3.6% in 2019, nearly 1pp below the NAIRU estimate, which itself was lowered by 0.1pp to 4.5%. The latter is part of an ongoing process which we expect to continue.

Interestingly, the Fed explicitly expects core PCE inflation to stabilise at 2.1% in both 2019 and 2020 which can be seen as a small indication that the Fed is indeed willing to allow a moderate overshoot here. Powell rationalized the only moderate inflation overshoot by arguing the Phillips curve is very flat. As always, one needs a certain assumption about supply side developments to make the growth and unemployment rate forecasts consistent with each other. For instance, if the participation rate stabilizes at the current level of 63% in the next two years (a big if) then underlying productivity growth of 1.5% will do the trick. This is certainly not beyond the realm of possibility but we have to acknowledge massive uncertainty. Because current underlying productivity growth is closer to 1%, there is a risk that the unemployment rate will fall below 3.5%.

If anything, Powell downplayed the importance of the dots further out into the future and seems to have somewhat less confidence in the stability of the Phillips curve compared to the consensus-driven academics Bernanke and Yellen. In this respect, he could be a bit closer to Alan Greenspan, who was also more agnostic on academic theory and more data-driven.

Powell also stated that the Fed is considering the case for a press conference at every meeting. This would have the advantage of making every meeting “live”, which the Fed always said it was but which the market never really believed. One reason to refrain from such a decision for now could be that it might encourage the market to start pricing a pace of hikes that is too fast. We believe that the median 2018 dot will shift to four at the June meeting, and maintain our base case of four hikes this year and three hikes next year.

Emerging markets: benign inflation

Emerging market bonds have been showing a resilience that is remarkable in the current environment. The most plausible explanation lies in the combination of reasonable-to-good growth and the benign inflation picture in the emerging economies. Last week, we focused on growth and we observed that, if anything, EM growth is improving again, thanks to a clear strengthening in domestic-demand-related indicators.

Inflation remains more stable than it has been in decades, despite the clear acceleration in growth during the past two years. Currently, weighted-average CPI in EM stands at 3.3% and has remained below 4% for more than two years now. The key explanations are the moderate growth pick-up and the currency appreciation since early 2016. Also important has been the increased fiscal discipline in some large EM economies such as Russia, India and Brazil. The deleveraging campaign in China has also played a role.

As long as growth in EM recovers only gradually, and as long as EM currencies do not depreciate sharply and commodity prices do not spike, EM inflation should remain in its tight range of 2%-4%. With the US dollar seemingly on a depreciating trend, EM currencies should continue to be OK. Meanwhile, there remain more EM central banks cutting rates than hiking rates. In the past week we have seen Brazil and Russia reducing their policy rates.

In this environment, we feel comfortable with our preference for local EM bonds over hard-currency bonds. We increased this trade this week by moving local bonds to +3 and hard-currency debt to -3.