Some thoughts on US monetary policy*

The US central bank – the Federal Reserve – has trimmed its key interest rate again, marking a further step forward down a new track. Its monetary policy is now developed independently of the US economic situation, as the Fed’s strategy is dictated by worldwide uncertainty that could hit the domestic economy and push it off its current robust path. Uncertainty on world trade, the impact of the administration’s trade policy and concerns on world growth are all prompting the Fed to adjust it strategy.

In the past, the country usually adopted a more accommodative stance in response to a sharp economic slowdown. In 2007/2008, the Fed changed its policy when liquidity dried up on the money market, but this was the exception rather than the rule, with the Fed only reacting to changes in the US economy with little concern for the rest of the world. This approach was only natural as world trends at the time were dictated by the US.

Fed backtracks after rate hikes in 2018

This shift in focus raises a number of points:
The Fed is backtracking after its upward trend in 2018, when it raised its key rate four times. These were the right moves at the time as the White House had implemented a very aggressive fiscal policy at a time when the economy was close to full employment, so it was vital to keep on a lid on tension that could have surged and dented the economy.
This rearrangement in the economic policy balance was perfectly plausible given economic conditions.
However, fiscal policy was not as effective as expected, and made a smaller contribution to driving the economy than anticipated, so the Fed no longer needed to continue its monetary tightening policy.
The outlook changed when the international context became more risky, particularly as a result of US trade policy.
The combination of these two factors prompted the Fed to maintain the status quo, then start easing, with a very clear timeline: on January 30, 2019 the Fed hit the pause button, then started easing on July 31, and again on September 18. Its policy is now highly accommodative as the real Fed Funds rate is only very slightly positive.

The US policy mix is now very accommodative, while the economic cycle is at a peak

It is interesting to take a closer look at economy policy measurements. The US policy mix is now very accommodative at a time when the country is still at the peak of the economic cycle. The public deficit stands at $1,000bn (almost 5% of GDP) and the real Fed Funds rate is only just slightly positive. Well might we wonder how the Fed will steer economic policy in the event of a shock on growth – can we expect an even bigger public deficit and should we anticipate negative interest rates from the Fed?

We could well think that the Fed rushed to change its accommodative strategy due to this unfortunate combination, as the economy is still robust and does not require monetary stimulus. It is also still very closed to outside influences, with trends and activity heavily dependent on the domestic market. This means that the role of external factors in the way monetary policy is managed is too high. In 2018, the degree to which the US economy was open[1] to outside factors was slightly under 14%, which is barely above the average since 2000 i.e. 13.7% vs. 13.4% average since 2000. The economy is no more dependent on the outside world than it was 10 or 15 years ago. So why change the factors that determine monetary policy by overlooking domestic aspects and only taking on board external dynamics?

Further questions on factors driving monetary policy

Questions to Jay Powell during press conferences should seek to address this question. Does this change reflect pressure from investors to get their hands on ever higher financial valuations? Is it the result of pressure from the White House as it wants the Fed to push interest rates ever lower? Is it because Powell has not set a clear doctrine on what monetary policy should be in this topsy-turvy world? These three factors can all be taken on board, but this rushed move makes for an economic policy error.

We can find another explanation for the Fed’s strategy

World growth is weaker than everyone would like. The world looks more fragmented than before and no longer has the coordination and cooperation momentum we saw just a few years back during the period of globalization. In other words, the dynamics of our world are increasingly diverging and this leads to uncertainty and dents growth.

Meanwhile, there no longer seems to be a way to conduct coordinated fiscal policy worldwide, and stimulus initiatives undertaken in 2009 seem to belong to a very distant past. The US, China and Europe have very differing views on this issue, so we should not expect a worldwide economic stimulus program, despite the fact that it would probably provide strong and sustainable support for the economy.

Central banks are all applying very accommodative policy to avoid putting any limitations on the world economy

In light of this situation, central banks worldwide are all applying highly accommodative policies to make sure they do not put any limitations on the economy. The aim is not to spur economic growth at any cost: growth projections from the ECB and the Fed most definitely do not point to this. Rather the goal is to limit the risks on world growth, and the ECB, the Fed, the Bank of Brazil and several other emerging country central banks have taken up this strategy, which can help explain why the aspects dictating US monetary policy focus on external factors.

Waiting for impetus from fiscal or technological factors

The only problem here is that this joint effort is admittedly necessary, but collective impetus looks a bit like a last-chance strategy while waiting for fiscal or technological stimulus to change the situation on a long-term basis. So central banks’ interest rates are set to stay low for a very long time to come: in this respect, the ECB indicated that its leading rate would stay where it is for such times as inflation does not move towards 2% on a structural basis. This could take a very long time – much longer than anyone expects. The Fed still has some leeway as compared to the euro area, but this could narrow very quickly.
The central banks are giving governments time to come up with some answers, but they will not necessarily hold on for as long as many would like.


* This document was posted on LeGrandContinent website. Le Grand Continent is a French think-tank on the geopolitical backdrop See the original post here in French
[1] The degree to which an economy is open to outside factors is the ratio between half of the total of imports and exports to GDP

The Federal Reserve reduces its rate as expected

The Federal Reserve reduced its interest rate by 25 basis points. It is now moving in the 1.75 – 2.00% corridor. The median rate for 2019 remains at the current level, therefore no further rate cut is expected in December. The monetary policy stance would be stable for 2020 at the end of 2019 level The reference rate would go up (25 bp per year) in the 2.00-2.25% corridor in 2021 and 2.25-2.50% in 2022. The long-term trend in the fed funds rate would then be 2.5% as in June.

The Fed and it’s chairman,Jerome Powell in his press conference, recognize that the economy is going pretty well. The central bank has marginally revised upward its growth forecast for 2019 to 2.2% against 2.1%.

The logic of the US central bank is as follows: the economy is doing well but its international environment is degraded. The decline in productive investment has thus to be perceived as evidence of the negative consequences of this uncertainty on the cycle. It is to strengthen the internal dynamics against external hazards that the Fed is loosening its monetary policy. This approach is new since generally the central bank becomes more accommodative when the economic situation is frankly weaker than currently observed.
This framework also means that in the event of a higher overall uncertainty, the Fed may not respect the rate profile derived from expectations. That’s what Powell said. Trade uncertainty and weaker global growth may create the need for lower rates to support domestic demand.

The main concern with such an approach is that the indicators of US economic policy are already very accommodative while the economy is at the peak of the cycle. The public deficit is $ 1,000 billion over one year in August and the real fed funds rate is now almost 0%. What mode of regulation will it be necessary to put in place during the economic downturn that will not fail to happen? I anticipate a sharp slowdown in the second half of 2020. Will the public deficit rise to 6 or 7% of GDP and the Fed rate land in negative territory?

Finally, we note that the measure taken does not reflect an unanimous vote . James Bullard wanted to go further while Esther George and Eric Rosengren were in favor of the status quo. As with the ECB, the measures taken no longer succeed in silencing differences. Behaviors change because the diagnosis is not so uniform.

The ZEW remains weak in September

The ZEW measured as the average of its two components remains in very negative territory in September. Its reversal mentioned here and there is very relative. The expectation component is less degraded but remain at a low level. The current conditions component has trending downward for at least a year and September is not immune to this negative dynamic.
The pace of the ZEW still suggests that the GDP figure will still be in the red in the third quarter. The upturn in activity and the reversal of the trend in the fourth quarter are not yet clearly perceptible.

The oil price jumped after the attack

After the attacks on oil installations in Saudi Arabia, the price, on Monday, climbed 13% over last Friday. This is an important jump, witnessing the Saudi’s decline in production by almost half of its capacity.

Immediately, Saudi Arabia announced that it would do what was necessary to quickly rebuild the destroyed facilities. At the same time, Arabs and Americans said they were ready to use their strategic reserves if necessary to avoid excessive tensions in the oil market.

However, this market has changed dramatically. Such an attack 10 or 20 years ago would have been apprehended as an oil shock, feeding the darkest scenarios. At this time, Arabia had a major role as the world’s largest producer and main regulator of the market. It was the only country that could quickly adjust its production. Arabia was the regulating country of the market. This is no longer the case. The United States is now the leading producer and its production continues to grow month after month.

The logic is not the same anymore. Americans may eventually adjust their production to reduce the losses from Arabia. It’s a completely different game that avoids getting into the logic of an oil shock

Moreover, if the price has risen rapidly but it is still below the prices observed last spring and almost 4 dollars below the average recorded in 2018. There is no danger.

For now, the rise is not strong enough and its duration too small to change rapidly the economic scenario. If Saudi rebuilds its facilities, the price may remain for some times a little higher than in recent weeks. But, the impact on inflation will be reduced. In October, last year, the price per barrel was higher than 80 dollars, even 85 dollars. This high price level then was the trigger for the yellow vests movement in France.

We could thus have a slight adjustment on prices, companies adjust the price rather quickly a few cents at best, but a negligible impact on inflation given the very high prices seen last year, significantly higher than those observed in the current period. .

An oil shock could only be perceived if tensions persisted and prices rose sharply every day. This market dynamic would then change with a persistent shift. It would also affect expectations of all the players in the economy, at the risk of provoking a self fulfilling negative shock. This is not the case.

We’re not at this stage yet as we don’t know the origins of the drones It is therefore difficult to perceive how the equilibrium has changed in the Middle East.

In 1973/74, the oil shock reflected the quadrupling of the price of oil after a very long period during which prices were very low. This is not the current configuration. Given the positions on the possible use of strategic reserves, the escalation of tensions in the oil market is far from the most likely scenario.

What to expect next week ? (September 16 – September 22, 2019)

Highlights

> The Fed’s meeting (18) will be the important event of the week. We expect a 25bp drop in the Fed’s main rate and nothing on the balance sheet policy.
The important point will be Powell’s explanation of this move at his press conference. In July, the main explanations of the 25 bp drop were external factors (trade, global growth). Will these elements remain the principal explanation ? What will be the new growth forecasts consistent with this new monetary policy stance ?

> The US industrial momentum (17) will be an important data as the ISM synthetic index for August dropped below the 50 threshold at 49.1. The consistency between the two indicators suggests that the industrial production index YoY change could go in negative territory.  Will the industrial index follow this dynamics in August?
The Empire state (16) and the PhilyFed (19) will give information on the economic situation in September

> The ZEW (17) in Germany for September  will be key to anticipate the possibility of a German recession and therefore the possibility for a more proactive fiscal policy. Draghi, in his press conference last Thursday, said that a eurozone fiscal policy would be complementary to the ECB monetary policy to boost growth and inflation.

> Chinese number (16) will show how the economic policy efficiency of an arbitrage between an external negative shock and the necessity to feed the domestic demand to stabilize the economic activity. Industrial production was weak in July while retail sales were stronger than a few months ago.
> Retail sales in the UK (19) in the midst of a political mayhem. What has been consumers’ behavior ? Have they increased their stocks to prevent the impact of a no deal Brexit ?
> US housing market with Housing starts (18) and Existing home sales (19)? The market is quite stable.
> In Brazil, the Selic will not be pushed down at the next monetary policy meeting (18) as the Brazilian central bank has had strong intervention on the forex market to limit the depreciation of the real.

The detailed document is here
NextWeek-September16-September22-2019

ECB accentuates financial repression for an extended period

The ECB has lowered its deposit rate by 10bp to -0.5% and will keep all of its rates at the current level or lower until inflation converges to 2%. In the ECB’s forecasts, inflation will be 1.5% in 2021. Therefore, the short-term rates will remain at the current level until at least 2022.
The ECB has also decided to resume it Quantitative Easing program (QE) by 20 billions euro from November the 1st.. This has already resulted in a spectacular decline of the 10y Italian rate.
This QE measure will accentuate financial repression. The aim is to push the entire rate structure for all countries in negative territory, Italy included. It can last beyond what we imagine. The purpose of financial repression is to reduce the incentive to save and to increase the incentive to spend to curb activity on the upside.
The wish of the ECB is that fiscal policy will change and be more active so that the measures taken are more effective and faster. However, he has been repeating this since the beginning of his term.
The ECB will reduce its deposit rate to -0.5% with the adoption of a system that will adjust this rate according to the type of reserve (tiering). Excess reserves will be paid at 0% and the rest at -0.5%.
The TLTRO is extended to 3 years and the rate on each transaction will be the main refinancing rate over the remaining time of this TLTRO tranche.
Given the length of the TLTRO and the expectations mentioned above on inflation, the applicable rate could be on average the deposit rate over the duration of the transaction for banks whose loans exceed the loan reference defined by the ECB. This means that for banks with excess liquidity, they may have an interest in lending and placing their loans in excess reserves. This will strengthen the banking sector.

The financial repression put in place by the ECB implies that interest rates for all maturities and for all countries are low and negative for a very very long time.
Economic players have changed their behavior when interest rates dropped to 0 or negative. But this change is now over. Behavior’s change will be marginal. The upward macroeconomic impact will therefore be very limited.
Moreover, the ECB’s signal could also be interpreted as reflecting a particularly degraded situation, thus raising concern for households and companies. Th risk is that signal may, at the end, have a negative effect on the economy. Will the stronger banking sector be enough to counteract this effect? It’s an unknown today.
Growth forecasts are revised downwards to 1.1% in 2019, 1.2% in 2020 and 1.4% in 2021. An external shock could tip the Eurozone into recession. For now, the ECB considers this probability to be very low.
This nonetheless reinforces the need for an effective and proactive fiscal policy to get out of the current liquidity trap whether or not there is a recession.
Given the lack of willingness of governments to have a coordinated fiscal policy, the position of Draghi is associated with a strong bet on the future at the risk of becoming wishful thinking.
Good luck Christine Lagarde

What to expect next week ? (September 9 – September 15, 2019)

Highlights

> The ECB meeting will be the most important event of the week. Bazooka measures are expected with lower deposit rate (associated with a tiering depending on the size of the bank) and the resumption of the Quantitative Easing Program.
> The lower deposit rate with tiering will help the banking system. The EONIA may even be higher than what is currently seen.
The QE program will push down all interest rates and reinforce financial repression
We do not expect strong impact on the Eurozone growth momentum or on its inflation.

> External trade in Germany will highlight the impact of the world trade lower momentum. Lower exports have pushed the German GDP change in negative territory during the second quarter. An extended slowdown of the world trade (as expected when we look at the worldwide lower exports orders in the Markit survey) would push Germany in recession.

> Retail sales in the US for August (13) are the last good numbers expected. In September, tariffs on Chinese consumer goods imported in the US will have a negative impact on consumers’ behavior.
> JOLTS (10) will show the probable change in the US labor market trend
> The UK economy  had a negative change figure in the second quarter. This will have an impact of the labor market (10) for July.

The detailed document can be read here
NextWeek-September9-September15-2019