The Fed muddies the waters

The latest FOMC meeting on January 29 and 30 saw confirmation of the halt to monetary normalization, with the end to the Fed funds hike cycle and an easing in the Fed’s balance sheet management (reduction) policy, although the exact terms of this remain to be seen. 
The most surprising part about this decision is that it was dictated by the threat of shocks from external factors (Brexit, China, etc.) rather than the desire to tackle any domestic problem, marking the first time that the Fed has taken this kind of decision to normalize monetary policy without making a direct reference to its domestic economic situation. 
Yet the shift in monetary policy direction could have been based on purely internal considerations rather than referring to potential external shocks, so this move raises a number of questions.

The Federal Reserve puts an end to normalization – My weekly column

The post is available in pdf format My Weekly Column – February 4

The US Federal Reserve decided to bring its monetary policy normalization to an end during its meetings on January 29 and 30, 2019.
The interest rate hike cycle had kicked off slowly in December 2015 and stepped up a pace a year later, as nine interest rate hikes pushed the Fed Funds rate up from 0.25% (upper end of range) to 2.5% in December 2018.
During last week’s press conference, the Fed Chair indicated that Fed Funds are now in the range of neutral, in response to the first question from journalists: there is no longer an accommodative or a tightening slant. Powell’s confidence in the strength of the US economy suggests that the end to normalization should not just be seen as hitting the pause button for a while.

The rate hike cycle has been long and slow-moving if we compare to the Fed’s previous series of tightening moves from 2004 for example. A comparison with this period also reveals that real interest rates on Fed funds were much higher then than they are now. The figure is currently marginally above the level witnessed at the start of the normalization process in December 2015, unlike the situation after 2004, when the economy was much more restricted, while this is not the case in the current economic situation.

A comparison of current real interest rates with previous phases of monetary tightening shows that today’s situation is completely different to these episodes.
Real interest rates in November 2018 stood at around 0.4% (inflation figures for December are not yet available on the PCE index), which is much lower than figures in 2006, 1999 or 1990. Does this mean that the US economy is too weak to be able to deal with a real rate above 1%? This would be extremely worrying and would undermine Jerome Powell’s comments that the US economy is in a good place.

It is difficult to understand why US normalization is coming to an end when we look at the economy, as unemployment is near its low, so the central bank should be tightening the reins. The Fed’s projections for 2019 and 2020 are for figures above the country’s potential growth rate and this also fits with the economists’ consensus, at least for 2019. Against this backdrop, monetary policy needs to be tighter to ensure that growth does not create imbalances that then have to be addressed, and this was the message from Powell in 2018, when he suggested that fiscal policy (too aggressive for an economy running on full employment) would need to be offset by tighter monetary policy to rebalance the policy mix. During the press conference on Wednesday January 30, he did not raise this question: the issue was side-stepped, but yet the analysis still remains the same. There are only two possible economic explanations for the halt to normalization: either there are expectations of a severe downgrade to projections when they are updated in March, but this would not be consistent with Powell’s comments; or the Fed is doing whatever it takes to extend the economic cycle at any cost, with the end to the rate hike cycle aimed at cutting back mortgage rates and taking the pressure off the real estate market. However, with the overall economy remaining robust, the risk of this type of move is that it could lead to imbalances that would be difficult to eliminate. This is the opposite approach to the Fed’s strategy right throughout 2018, so it would be a strange tactic.

The Federal Reserve tells us one hike now and two next year

The Fed raised its benchmark rate by 25 basis points. The fed funds rate will thus evolve in the 2.25 – 2.5% corridor. This rate level is close to the corridor, 2.5-3.0%, considered by the Fed as a long-term target. This is the 4th rise this year.

The central bank does not appear worried about the pace of the economy in the coming months. Growth will slow down somewhat in 2019, but the unemployment rate will remain close to its current level, beyond full employment. Inflation will be close to 2%. It is a little weaker than at the September meeting because of the drop in the price of oil.

The Fed said it could raise its benchmark rate twice in 2019. In September, at the previous meeting, it was considering 3 rises. The pace of oil prices and its effect on the inflation rate probably explain this lessening.

Why two further hikes: the economy still operates on a trend beyond full employment. This imbalance must be offset by a monetary policy that must become a little restrictive to avoid possible imbalances, currently not very visible but that could develop in the not too distant future. The economy has changed, but not so much that it can function too long beyond full employment without having consequences that are difficult to manage in the long run. In addition, the White House policy that fuels domestic demand is resulting in a rapid rise in imports (see here). Through a somewhat restrictive monetary policy the Fed must weigh on the demand and limit the external imbalance.

The ECB ready to maintain its accommodative policy in 2019

The ECB puts all its energy on it but inflation does not converge frankly towards the objective (2%) it has defined. Can we say, like Mario Draghi, that the Quantitative Easing has worked properly?
Yes probably on the activity. The fall of all the interest rates has modified the inter-temporal trade-off on consumers’ side favoring the immediate expenses to the detriment of the future expenses.
On inflation? Yes, if the recovery helped to avoid deflation but beyond? We can wonder. Convergence towards the ECB’s target is postponed year after year.
Forecasts on growth (convergence towards potential in 2021 estimated at 1.5% by the ECB) and on inflation, suggest, except to change the reaction function, that the ECB will remain accommodative for a extended time.

The ECB will be unable to normalize its monetary policy soon

The ECB will not start the normalization of its monetary policy in 2019. The interest rate level will remain stable, my bet is that the refi rate and the deposit rate will remain at the current level in 2019.
The lack of external impulse, the slower momentum in the manufacturing sector and the convergence of the headline inflation rate to the core inflation rate are three reasons that suggest that the ECB will not take risks in the management of its monetary policy. The monetary policy normalization, even the expectation of it, may weaken economic activity. Therefore it’s not the good policy when the inflation rate is way below the ECB target with no convergence to the target in a foreseeable future.

The framework I have in mind is the following: Due to more heterogeneous behaviors and uncertainty at the political level, global growth will become, in 2019, weaker than in 2017 and in 2018. Inside the Euro Area, there are no coordinated policies that may boost growth, therefore growth trajectories will converge to potential growth. This framework is not a source of monetary policy normalization. But we can add that the dramatic oil price drop in recent weeks (due to excess supply in the US and in Arabia) will push the headline inflation rate to the core inflation rate which has been close to 1% for months. It’s still way below the ECB target and therefore not a source of monetary policy normalization.  Continue reading

Trump and the Federal Reserve

Donald Trump hit out again recently at the Federal Reserve for its monetary policy management, taking it to task for hiking interest rates, which he claims would hamper US growth. But this is something of a bold statement given the White House’s fiscal policy.
The chart below depicts US unemployment and the government balance as a percentage of GDP, revealing that the two indicators have trended in a similar way over almost 60 years, each reflecting the US cycle. When economic activity is robust, jobless numbers decrease, while at the same time, tax income increases and spending to support the economy is lower, thereby improving the budget balance. This twofold trend has always worked well, even when Ronald Reagan embarked on economic stimulus at the start of the 1980s. Meanwhile, the budget surplus at the end of the 1990s is also an illustration of this trend, with Bill Clinton’s – fairly smart – moves to implement austerity policies to gain leeway in the event of a downturn in the cycle.

But the current period marks an exception. The cycle is robust, as reflected by the drop in unemployment to 3.7% in September 2018, hitting its lowest since 1969, yet the government balance is not improving, but rather it is deteriorating under the influence of Donald Trump’s policies. The public deficit stands at close to 5%, yet it should have fallen significantly on the back of the economic cycle. The government is driving economic stimulus at a time when the economy is running on full employment.

So it is reasonable for the Fed to take action to counter these excesses and avoid the emergence of persistent imbalances. We cannot rule out the possibility that fiscal policy will bolster domestic demand, triggering a significant surge in inflation and a larger external imbalance despite the White House’s protectionist measures (demand is rising sharply – due to tax cuts and increased spending – and supply does not have time to adjust, which leads to a swell in imports).

The Fed, as embodied by Chair Jay Powell, has clearly indicated that this policy is not sustainable in the medium term and that it must be offset, which is why the Fed is hiking interest ratesand it is right to do so – thereby setting the US economy on a more sustainable path for the medium term.

However, the risk lies in the event of a severe negative economic shock, as there would be no leeway for fiscal policy to adjust, and there would be no scope for raising the budget deficit or implementing a stimulus plan like Obama did in 2009, as the budget deficit is already extensive before a potential shock: the US economy would therefore be hampered over the long term. Trump’s policies will only help the better-off in society, who benefit from lower taxes, while the cost of this policy is spread out across the population via the ensuing increase in the public deficit. And this approach will create even more inequality in the longer term as some Republicans are alarmed at the extent of public debt and are arguing for a reduction in social spending to make this debt sustainable in the medium term. For now, America seems to have lost sight of the meaning of the words equality and fairness.unemploymentand budgetdeficitUS

The Federal Reserve has increased its rate by 25bp and will continue to tighten in 2019

The Federal Reserve raised its benchmark interest rate by 25 basis points. The effective rate will evolve in a corridor between 2% and 2.25%.
The dots graph reflecting monetary policy committee members’ expectations suggests 3 rate increases in 2019, 1 in 2020 and none in 2021.
This profile, for 2019 and 2020, is unchanged from last June forecasts. The introduction of 2021, an additional year, nevertheless shows the end of the monetary tightening. It is set a final point to hardening with a slightly higher interest rate than long-term anticipation. The Fed’s rate would then evolve in a corridor ranging from 3.25% to 3.5% against a long-term equilibrium rate of 3%. The Fed needs to move above the latter to be restrictive and avoid the formation of imbalances that could harm the economy.

The press release is identical for the most part to that of June (see here the comparison). The changing part is important, however, since the Fed no longer refers to the accommodative nature of its monetary policy. It is now close to neutrality. Continue reading