What to expect next week ? (July 1 – July 7, 2019)

Highlights

  • The ISM index for the manufacturing sector (July 1) will be the main indicator in the coming week. The slowdown in the US business cycle may be confirmed in June. 
  • The US labor market is the other main indicator (July 7). Its dynamics has recently changed as it adjusts to the new business cycle shape.
  • The Markit indices for the manufacturing sector (July 1) and for the services sector (July 3) will show the risk of a global recession for the manufacturing sector. The hope for the Eurozone is a strong services sector index that will allow an extension of the growth momentum.
    The Tankan survey in Japan will be out on July 1.
  • Employment in Germany for June (July 1) and retail sales for May (July 3) will show the possibility of maintaining a robust domestic demand or if it is necessary to have a stronger economic policy to cushion the impact of world trade negative shock on the German economy.
  • Retail sales in the Euro Area (July 4) for May will be a good proxy on the strength of the internal demand for the Euro zone.

    The document is here NextWeek-July1-July7-2019

Inequality

Issues on inequality are more and more discussed. These questions were not mentioned when I was a student in the 80’s. They à re now part of the economic discussion at the academic level and elsewhere. Angus Deaton and the Institute for Fiscal Studies (IFS) in the UK have launched a first report on inequality. It can be found here. Deaton gave a speech that explains all the diversity of the term inequality and its consequences.

The quote below is the last paragraph of his speech

“I think that people getting rich is a good thing, especially when it brings prosperity to others. But the other kind of getting rich, “taking” rather than “making,” rent-seeking rather than creating, enriching the few at the expense of the many, taking the free out of free markets, is making a mockery of democracy. In that world, inequality and misery are intimate companions.”

The speech from Angus Deaton launching the IFS report on inequality can be found here

Can we expect lower Fed’s rate in July ?

The possibility of a 50 basis point interest rate cut by the US Federal Reserve is on everyone’s lips. The dots chart published at the end of the June 19 meeting indicated that rates would remain at the current level in 2019, but it showed that 7 members suggested a 50 bp decrease in 2019 (stability is calculated on the median of the results).
That was all it took for observers to switch to a similarly sharp decline at the July 30-31 meeting. The explanations given are those of Donald Trump’s pressure on the central bank either through threats relayed on Twitter or by the members appointed by Trump to the FOMC.

Such an interpretation raises several questions
The first is that at the Fed, the president always has the last word. Jerome Powell’s recent comments do not give this sense of urgency about lowering rates. This implies that the July rate cut, if it were to take place, would be more than a palace revolution since its president would be outvoted.

The second point is that the macroeconomic data also do not reflect the urgency of a change in the central bank’s strategy.
To gauge the economic situation I used the CFNAI index calculated by the Chicago Fed. It includes 85 indicators of the federal economy (from industrial production to retail sales, employment and orders for durable goods). The calculated indicator is centered on 0, and a value below -0.7 (on the index on average over 3 months as shown in the graph) suggests a risk of recession.

Since 1985 (the beginning of the great moderation), I have then measured the changes in the pace of the Fed’s monetary policy. The first graph shows the fed fund rate and the points used to mark the shift towards an accommodative monetary policy.

The second graph shows the dates of monetary policy changes and the CFNAI index.
Since 1985, monetary policy changes have taken place when the CFNAI index is close to -0.7, i.e. when the risk of recession becomes clearer. The only exception is 2007 when the issue of liquidity on many financial structures was raised. This is a special case.
The current level of the index is not consistent with a decline in Fed rates unless we imagine a deep break in all US indicators for June and July. This is not our scenario.

This means that, in the absence of economic or financial justification, a reduction in the Fed’s rates and a defeat of its President would first reflect a collapse in the credibility of the US central bank due to its loss of independence. As the world’s most powerful financial institution, it is likely to cause significant turmoil in financial markets. Should we take this kind of risk? I don’t think so.

The Fed’s message in 8 points

The Federal Reserve message is clear:

1- Macro data remain robust and expected inflation is low

2-Risks on the economic prospects are on the upside

3 – The Fed will adjust its rate if necessary but nothing is on the agenda

4 – The dots’ graph doesn’t give information as it shows one drop in 2020 and one hike in 2021

5 – Powell introductory statement indicates a bias on the downside for the Fed’s rate in the future.

6 – Long term rates dropped on this perception even if nothing has been said on the agenda. The 10y is now below 2% and the 30y below the fed funds rate for the first time in this cycle

7 – In the past, when all rates are below the Fed’s rate it’s a signal of recession. The drop in the Fed’s rate will come but will not be sufficient to avoid a recession.

8 – The reason is that low long term interest rates reflect low expectations on the future. They can’t reverse spontaneously. Economic phenomena are persistent

The Fed is in no hurry to adjust its monetary policy

In its monetary policy statement, the Fed says there is no reason to lower interest rates rapidly. Activity data are still robust and inflation remains moderate. Therefore, as long as there is no sudden inflection, there is no reason for the central bank to rush to adjust its monetary policy. (This is what I mentioned here)

The dots’ graph, reflecting the FOMC members’ expectations, considers that the fed funds rate will be stable in 2019, decline once in 2020 before going back up again. in 2021 at the current level.

The US central bank, which does not want to hurry given the economic situation still strong, does not want to give signals on what it will do. This is the end of the Fed’s forward guidance. It does not commit to anything, thus confirming its desire not to tie hands with commitments that may not be in line with changing circumstances.

ECB: How to burn ammunition for nothing

In Sintra, at the ECB seminar, Mario Draghi stressed the risk on growth and the difficulties of converging to the inflation target (close but below 2%).

If additional risks materialize then the ECB could reduce its rates and restart an asset purchase procedure. The idea is to take back and accentuate what has been the success of the ECB since 2013. (Low rate = less incentive to defer its wealth over time given the low return associated with it.it has been strong support for a stronger momentum for the domestic demand)

At the same time, Draghi called for an active economic policy. On this point, the failure to implement a euro area budget reflects non-homogeneous behavior in the euro zone. As a consequence there will be no common fiscal policy in the euro area. One can not therefore imagine a two-component euro-zone policy.

A major rule of the theory of economic policy is that it requires as many instruments as objectives. There are two objectives (growth and inflation) and one instrument, monetary policy.

This will not work especially with a series of negative external shocks. In 2016/2017, monetary policy benefited from a favorable international context even if fiscal policy was not active. Today, the environment is no longer as buoyant and the absence of fiscal policy will make it difficult to cushion external shocks. The ECB will act alone and becoming more accommodating it will burn ammunition for a poor result.