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.
ISM index dropped: a healthy adjustment. In the USA, the fall of the ISM may reflect a return to a more normal situation? For many months, this indicator for the manufacturing sector was well above the CFNAI index which is a measure of 85 indicators of the economic activity (prepared by the Chicago Fed). This situation, which has been a regular occurrence since 2004, always ends with a sharp and brutal adjustment of the ISM to the CFNAI. The adjustment always takes place in this direction. Finally, the overly optimistic expectations contained in the ISM index adjust to the “real economy” which does not present excessive optimism. This adjustment is rather healthy.
First step the 5yr-2yr spread is now null before being negative with the Fed tightening. Then the 10yr-2yr will flatten before being negative for the same reason. This has always been a signal of recession. This time is not different and 2020 can be anticipated for it.
The two curves have the same pattern even if levels are different. They provide the same message for 2020.
US job growth is buoyant, but is it all down to the Trump effect? The US economy created 250,000 jobs in October, which is a bit higher than the average of 213,000 witnessed since the start of the year. However, October is usually a fairly good month for new job creation, with 271,000 in October 2017, and an average of 246,000 in the month of October since 2013 as compared to an average of 206,000 for other months.
The labor market is buoyant overall, reflecting a solid pace of economic growth although nothing to write home about with 2.25% per year on average since 2011. Continue reading →
The Federal Reserve meets on September 25 and 26, and a 25bps hike to the fed funds rate is expected, putting the effective rate in a range of between 2% and 2.25%, with another hike expected in December. The Fed now seems to agree on these four monetary tightening moves for 2018, so the next big question is 2019. During the latest update of economic and financial projections from the members of the Federal Open Markets Committee (FOMC) in June, three interest rate hikes were expected in 2019. How can we get a clearer idea of what’s to come?
Four interest rates are now confirmed by the Fed. I had mentioned this scenario at the start of the year due to the White House’s implementation of expansionary fiscal policy and I have not changed my mind: the hike to the fed funds rate is just a way to iron out the imbalances caused by this policy that seeks to fuel domestic demand.
This domestic momentum reflects the impact of two factors: the first is the direct effect of tax cuts and rising public spending, and we can see the positive effects of this twofold approach for demand; the other component is trade policy that aims to use domestic production to replace imports, thereby sharply driving up demand for companies’ goods and services.
So the White House has adopted a two-pronged approach: on the one hand it bolsters domestic demand and the other it directs this additional demand towards US companies rather than imports.
This internal momentum will have at least two direct consequences: the first is the risk of inflation because demand is strong and because of higher import duties. Continue reading →
What were last week’s major changes? The main change was in Italy with a strong and rapid drop in the interest spread with Germany.
Why ? Since the new coalition government came to office, fears have emerged on exactly how the campaign-trail program would translate into the forthcoming budget – an answer to this question is expected on September 27.
The government’s stance so far has been to be fairly relaxed, especially on the 3% threshold (of budget deficit as % of GDP), which explains why the yield spread with Germany widened considerably over recent weeks.
This was a source of concern as the Italian economy would soon have run up against financing difficulties due to the reluctance of non-resident investors – who hold around 35% of the country’s debt – to revisit the Italian market after withdrawing their investment in the country all summer. Italians cannot and do not want to leave the euro area, so additional pressure on liquidity and interest rates could have hampered funding for Europe as a whole.
However, the economic situation is swiftly changing in Italy, as economic activity slowed sharply over the summer months, Continue reading →
Let’s start with the global outlook – are signs on the world economy still as robust as they were?
The situation has changed since the start of this year. The world economy was fuelled by faster world trade growth in 2017, but this is no longer the case. Trade momentum has slowed since the start of 2018 and no longer looks able to drive the same impetus across the economy as a whole.
Business surveys worldwide point to a slowdown in export orders, reflecting more sluggish momentum worldwide. Why did we see an acceleration in 2017? Central banks loosened monetary policy in 2016, at a time when inflation was low in most countries, bar a few exceptions such as Russia and Brazil. The Federal Reserve raised its leading rates at a very slow pace and steered its communication to ensure that investors were not spooked, especially in emerging economies.
More accommodative monetary policies kindled domestic demand in each country, spurring on economic activity and trade, and triggering broad-based momentum that was beneficial for all concerned and set the world economy on a virtuous trend.