Federal Reserve

The US CPI report for June, published on Friday, was the fourth successive monthly print that surprised on the low side. Initially, these inflation misses were dismissed by the Federal Reserve as idiosyncratic and temporary, but they are now becoming too persistent to ignore. If they are not reversed fairly soon, the FOMC will need to give greater weight to the possibility that inflation may not return to target over the next couple of years.

Janet Yellen appeared to open the door to this possibility for the first time in her evidence to Congress last week. In a distinct change of tone, she specifically mentioned uncertainties about “when and how much inflation will respond to tightening resource utilisation”, thus acknowledging the possibility of alterations in the Phillips Curve.

She also emphasised that monetary policy is not on a preset course, adding that the FOMC will be carefully monitoring whether the recent decline in inflation is reversed in the months ahead. Normally, her guidance on data is more even handed, without specifically highlighting downside inflation risks.

My colleagues at Fulcrum (especially Juan Antolin-Diaz and Alberto Donofrio) have recently estimated some new econometric models [1] to track the course of inflation in the US, and these models identified the importance of the latest inflation surprises fairly early in the process. After the latest CPI data, the models suggest that there is a high and increasing chance that US inflation will fail to return to target within the next 2 years. Read more

In this month’s regular temperature check on global economic activity, the Fulcrum nowcasts identify a continuing strong and co-ordinated global expansion, with no significant signs of any meaningful reversion to trend, especially in the advanced economies. We reported a couple of months ago that the very robust rates of growth in the US and China had come off the boil, but these economies have since rebounded again, and the Eurozone has continued to record stellar rates of expansion by its own subdued standards.

Rather belatedly, the consensus growth projections published by mainstream economic forecasters have begun to reflect these strong activity reports, despite the aberrantly weak GDP data in the US in 2017 Q1. These upgrades to global growth projections break the dismal pattern of repeated downgrades that has been experienced ever since 2012.

It is unclear whether these improvements represent merely a short term cyclical recovery based on expansionary demand policy. The absence of any rise in core inflation suggests that, at the very least, supply has so far been able to match any increase in demand, though it is far too early to conclude that this will prove sustainable.

John Williams, President of the San Francisco Fed, strongly expressed the mainstream, pessimistic view about supply side growth in a good speech last month. Nevertheless, it is worth at least considering the possibility that a very modest supply side improvement may finally be underway, while recognising that the case will be unproven for a very long time to come.

The Fulcrum monthly nowcasts are attached hereRead more

Markets are becoming concerned about the central banks’ response – or rather their lack of response – to a series of inflation releases that have surprised economists on the low side recently. A few months ago, with the oil price shock of 2014-16 fading into history, it seemed that the Federal Reserve and the ECB were on a relatively smooth path towards attaining their inflation targets of around 2 per cent over the next three years. Now, that seems much less certain.

In the US, there have been three successive monthly inflation reports that have been much lower than forecast. In the eurozone, the monthly path has been bumpier, but the upshot is that core inflation has been stuck at 1.0 per cent, showing no sign of any progress towards target.

Bond markets have adjusted their inflation “breakevens” downwards. Although this has been in part driven by a widening in negative inflation risk premia, it seems to imply a loss of confidence that the global reflationary forces are gaining momentum.

When inflation surprised on the downside after the oil price collapse in 2014, the major central banks eventually responded by aggressively adding to monetary stimulus (in the case of the ECB), or by postponing the intended tightening (the Fed). This time, the central banks have completely refused to alter their planned monetary stance, and several of them – notably including the ECB – have been making more hawkish noises.

Although the drop in inflation has been very modest compared to 2014-15, some commentators have started to worry about a “Sintra pact” among global central bankers to normalise interest rates.

So what is going on, and does this new policy response spell danger for risk assets? Read more

In January 2012, the FOMC started to publish its “dot plots” showing the committee’s median expectation for the fed funds rate several quarters ahead. Ever since then, it has become customary to compare the Fed’s dots with the market’s forward pricing for the funds rate over the relevant horizon. Frequently, the dots have been much higher than the market pricing, and this has usually been taken as a signal that the market expects a more dovish stance for monetary policy than implied by the FOMC.

Lawrence Summers recently took this argument a step further, arguing that the gap between the dots and the market’s path for rates suggests not only that the Fed will not, but should not, raise rates. He believes that the dot plot comparisons show that investors do not see sufficient justification for a monetary tightening in the near future. In supporting evidence for this, Professor Summers points to the forward path for inflation built into the inflation-linked bond market, which is also much lower than the inflation path predicted by the FOMC.

It does not normally pay to disagree with Larry Summers, and he may well be right about the immediate future for Fed policy. Inflation is clearly coming in lower than expected.

Nevertheless, it is worth examining the Summers argument in greater detail, since the existence of risk (or term) premia in the market’s forward pricing for interest rates and the inflation rate can scramble the message that investors should take from these readings. Read more

In this month’s regular update on global activity data, the Fulcrum nowcasts have continued to report that the world economy is expanding at slightly above trend rates. As we noted last month, there have been some signs of a modest slowdown in the US, but the Eurozone, Japan and the UK have remained fairly robust. China had shown a few signs of slowing in the spring, but the most recent growth estimates have rebounded to the 7 per cent average that has been intact for several previous quarters.

There now seems to be less chance that the global economy will achieve a clear upside break in its growth rate this year, but there are no signs of a significant or broadly-based slowdown either.

As we have noted on many occasions, the global financial markets have been in a regime that has come to be known as “global reflation” since March, 2016. However, some of the elements of that regime, including rising inflation expectations in the bond markets and a firm US dollar, have clearly frayed at the edges, following a decline in the market’s confidence that a sizeable fiscal reflation package will be introduced by the Republican administration in Washington, and the publication of weak inflation reports in the US and the Eurozone.

The current market regime is probably better described as one of “global expansion” rather than “global reflation”. In retrospect, that would have been a more accurate description of the entire market regime that started last year, since this period has always been about rising real output growth, rather than rising core inflation.

The latest monthly nowcasts are presented in detail here. Read more

A few months ago, the Federal Reserve seemed determined, at long last, to normalise monetary policy in the US. In fact, it still seems to be set on that course. The FOMC has indicated that it intends to raise rates in June by a further 0.25 per cent, and they also seem ready to announce a plan to shrink the central bank balance sheet in September.

But there is now a fly in the Fed’s ointment. The last two monthly releases for consumer price inflation have been much weaker than anyone expected. Although the FOMC was fairly dismissive of the first of these announcements – saying in the minutes of its May meeting that it was probably caused by temporary or idiosynchratic factors – it is not yet known whether they have continued to ignore the second set of weak CPI data in April. The two months together have left core CPI inflation 0.4 percentage points lower than expected.

When the PCE deflator is released next Tuesday, it will probably show the 12-month core inflation rate at 1.5 per cent in April, the lowest figure since the end of 2015. The FOMC’s reaction to this incoming news will depend on their reading of the underlying causes of low inflation, which are highly uncertain. But the markets have already decided that they will take the evidence seriously enough to abort their programme of rate rises after the planned June increase. Read more

The Federal Reserve is actively considering a profound change in US monetary policy, in effect the reversal of quantitative easing (QE). In its March meeting, the FOMC discussed its strategy for the future run down of its balance sheet, and said that further debate would take place in upcoming meetings.

The FOMC has already concluded that “a change in the Committee’s reinvestment policy would likely be appropriate later this year” and that this would need to be flagged “well in advance”. The minutes to the May meeting (to be published on 24 May) will probably provide some further indication about their thinking on this important topic.

Investors are therefore beginning to focus on the possible consequences of the reversal of QE on interest rates and the shape of the yield curve.

In a previous column, I outlined the likely path for the US central bank balance sheet under the new policy, and predicted that this would cause global QE to turn negative in 2019, after being consistently positive by about 2 percentage points of global GDP in every year since 2011. The great unknown is whether this reversal of central bank support will remove the underpinnings from the bond market, risk assets and the global economic upswing.

I take the optimistic side of this debate, but investor opinion is sharply divided on the matter. Read more

One of the most dramatic monetary interventions in recent years has been the unprecedented surge in global central bank balance sheets. This form of “money printing” has not had the inflationary effect predicted by pessimists, but there is still deep unease among some central bankers about whether these bloated balance sheets should be accepted as part of the “new normal”. There are concerns that ultra large balance sheets carry with them long term risks of inflation, and financial market distortions.

In recent weeks, there have been debates within the FOMC and the ECB Governing Council about balance sheet strategy, and it is likely that there will be important new announcements from both these central banks before the end of 2017. Meanwhile, the PBOC balance sheet has been drifting downwards because of the large scale currency intervention that has been needed to prevent a rapid devaluation in the renminbi. Only the Bank of Japan seems likely to persist with policies that will extend the balance sheet markedly further after 2017.

Globally, the persistent increase in the scale of quantitative easing is therefore likely to come to an end in 2017, and it is probable that central bank balance sheets will shrink thereafter, assuming the world economy continues to behave satisfactorily.

Investors have become accustomed to the benefits of “QE infinity” on asset prices, and are cynical about the ability and desire of central bankers ever to return their balance sheets to “normal”. They will have to adjust to a new reality fairly soon. Read more

The global economic recovery that started amid the gloom of the financial crash in March 2009 is about to celebrate its 8th birthday. In the advanced economies (AEs), the GDP growth rate during this recovery has averaged only 1.8 per cent, well below normal, but unemployment has dropped from 8.1 per cent to a still fairly high 6.1 per cent. According to JP Morgan, the volatility of GDP growth has fallen to the lowest levels for four decades since 2014.

This slow but extremely steady period of expansion has of course been accompanied by much lower interest rates, which have proven terrific for asset prices. The index of total equity returns in the AEs has tripled since the bear market ended.

Janet Yellen and other officials at the Federal Reserve have said on many occasions that “recoveries don’t just die of old age”. Unless something goes wrong, the upswing in the cycle will be prone to continue. At present, econometric models that attempt to assess recession risks suggest that these risks are exceptionally low over the next 12 months.

Furthermore, the growth rate in the US and other AEs seems, if anything, to be breaking upwards. This may be because the headwinds that have held growth down for so long – excessive debt, a malfunctioning banking system, extreme risk aversion, low capital investment etc. – may finally be fading away. Perhaps the world economy is at last attaining escape velocity.

However, good times cannot last forever. It is common for euphoria to set in just when the economic and financial cycle is nearing a peak. As in 2001 and 2008, the end could come much sooner than anyone predicts [1]Read more

The robust US employment data last Friday have left almost no room for doubt that the Federal Open Market Committee will raise short term rates by 25 basis points on 15 March, and will probably warn of two or three more hikes to come this year.

Analysts seem confident that this accelerated phase of Fed tightening will involve a further rise in bond yields and the dollar, and many active fund managers are positioned for both these events to occur in coming months. Other analysts believe that the more hawkish Fed will puncture the “euphoria” in the US equity market before too long. Read more

US monetary policy has now clearly embarked on an important new phase. For a long while, the markets have been extremely reluctant to recognise that the Federal Reserve might actually mean what it says about increasing short term interest rates by 0.25 per cent on three separate occasions this year. Remembering repeated episodes in which the Fed has failed to deliver its threatened tightening in policy since 2013, investors have concluded that dovish surprises from the Fed are endemic.

Last week, however, they woke up to the fact that FOMC really is serious about raising rates in March, and that this may be the first of three or even four rate hikes this year. After a series of hawkish speeches by several FOMC heavyweights, the coup de grâce came on Friday, when Janet Yellen warned that a rate rise in March “would be appropriate” unless economic data surprised in the meantime. She added rather ominously that policy accommodation would be removed more rapidly this year than in 2015 and 2016.

The great unknown is whether this will come as a major shock to the financial markets. It will certainly mean that investors will need to build in a faster path for rate hikes in the near term than anything that has previously been contemplated in this cycle. But the good news is that the final destination for rates does not seem to be changing, at least in the view of the FOMC. The Committee is increasing the speed of travel towards its destination, but is not changing the destination itself.

So what has justified the shift toward more hawkish thinking on the FOMC? And will this upset the equity market, which is still ignoring the prospect of higher rates? Read more

A year ago, Lawrence Summers’ perceptive warnings about the possibility of secular stagnation in the world economy were dominating global markets. China, Japan and the Eurozone were in deflation, and the US was being dragged into the mess by the rising dollar. Global recession risks were elevated, and commodity prices continued to fall. Fixed investment had slumped. Productivity growth and demographic growth looked to be increasingly anemic everywhere.

Estimates of the equilibrium real interest rate in many economies were being marked down. It seemed possible that the world economy would fall into a “Japanese trap”, in which nominal interest rates would be permanently stuck at the zero lower bound, and would therefore not be able to fall enough to stimulate economic activity.

Just when the sky seemed to be at its darkest, the outlook suddenly began to improve. Global reflation replaced secular stagnation as the theme that dominated investor psychology, especially after Donald Trump’s election in November. Why has secular stagnation lost its mass appeal, and has it disappeared forever? Was it all a case of crying wolf? Read more

President Trump has an almost unprecedented opportunity to reshape the key personnel and legal basis of the Federal Reserve in the next 12 months, essentially rebuilding the most important economic organisation in the world in his own image, if he so chooses.

The President may be able to appoint five or even six members to the seven-person Board of Governors within 12 months, including the Chair, Vice Chair for monetary policy, and a new Vice Chair for banking supervision. He may also be able to sign into law a bill that alters aspects of the Fed’s operating procedures and accountability to Congress, based on a bill passed in 2015 by the House of Representatives.

Not surprisingly, investors are beginning to eye these changes with some trepidation.

Some observers fear that the President will fill the Fed with his cronies, ready to monetise the budget deficit if that should prove politically convenient. Others fear the opposite, believing that the new appointments will result in monetary policy being handed over to a policy rule (like the Taylor Rule) that will lead to much higher interest rates in the relatively near future. Still others think that the most important outcome will be a deregulation of the banking system that results in much easier credit availability, with increased dangers of asset bubbles and economic overheating.

It is not difficult to see how this process could work out very badly indeed. But, at present, I am optimistic that a modicum of sense will prevail. Read more

Exactly a year ago this week, the mood in the financial markets started to darken markedly. As 2015 had drawn to a close, financial markets had seemed to have weathered the first increase in US interest rates since 2006 in reasonable shape. The Federal Open Market Committee had telegraphed its step to tighten policy in December 2015 with unparalleled clarity. Forewarned, it seemed, was forearmed for the markets.

Meanwhile, China had just issued some new guidance on its foreign exchange strategy, claiming that it would eschew devaluation and seek a period of stability in the RMB’s effective exchange rate index. This had calmed nerves, which had been elevated since the sudden RMB devaluation against the dollar in August 2015.

A few weeks later, however, this phoney period of calm had been completely shattered. By mid February, global equity markets were down 13 per cent year-to-date, and fears of a sudden devaluation of the RMB were rampant. It seemed that the Fed had tightened monetary policy in the face of a global oil shock that was sucking Europe and China into the same deflationary trap that had plagued Japan for decades. Secular stagnation was on everyone’s lips.

We now know that the state of the global economy was not as bad as it seemed in February, 2016. Nor was the Fed as determined as it seemed to tighten US monetary conditions in the face of global deflation. And China was not set upon a course of disruptive devaluation of the RMB. Following the combination of global monetary policy changes of February/March last year, recovery in the markets and the global economy was surprisingly swift.

A year later, the key question for global markets is whether the Fed and the Chinese currency will once again conspire to cause a collapse in investors’ confidence. There are certainly some similarities with the situation in January 2016. The Fed has, once again, tightened policy, and China is battling a depreciating currency. But there are also some major differences that should protect us this time. Read more

As the global economy enters 2017, economic growth is running at stronger rates than at any time since 2010, according to Fulcrum’s nowcast models. The latest monthly estimates (attached here) show that growth has recovered markedly from the low points reached in March 2016, when fears of global recession were mounting.

Not only were these fears too pessimistic, they were entirely misplaced. Growth rates have recently been running above long-term trend rates, especially in the advanced economies, which have seen a synchronised surge in activity in the final months of 2016. Read more

The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.

This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.

There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail. Read more

The response of the financial markets to the US election result has been almost as contradictory as the rabble rousing campaign of the President-elect himself. Unmitigated gloom in the hours after the Trump victory was swiftly followed by a euphoric atmosphere in US markets.

Investors are apparently assuming that the new administration will usher in a mix of fiscal reflation, prudent monetary policy, deregulation and tax cuts that will prove very good for the American economy. Trade controls are seen as damaging the emerging economies, but not the US. A steeper yield curve is seen as reflecting a “better” mix between fiscal and monetary policy.

With one very graceful acceptance speech, Donald Trump has suddenly morphed into Ronald Reagan in the markets’ consciousness. Read more

Hillary Clinton and Donald Trump

Hillary Clinton and Donald Trump  © Getty Images

Presidential elections have often marked major changes in American attitudes towards fiscal policy.

The arrival of President Kennedy in 1960 represented the beginning of Keynesian fiscal activism. President Nixon’s election in 1968 marked the high point of inflationary budgetary policy designed to finance the Vietnam War.

President Clinton in 1992 ushered in a period in which the reduction of public debt was paramount. The elections of President Reagan in 1980, and George W. Bush in 2000, marked eras in which tax cuts took precedence over budget balance, and counter-inflation policy was ceded to the Federal Reserve.

As the 2016 election approaches, investors are wondering whether another major change in the approach to fiscal policy is in the works. Is a lurch towards fiscal stimulus the “next big thing” in Washington? Possibly, but I am not convinced. Read more

The new UK chancellor Philip Hammond

The new UK chancellor Philip Hammond  © Getty Images

Until recently, the rate of expansion in global central bank balance sheets seemed likely to remain extremely high into the indefinite future. Although the US Federal Reserve had frozen its balance sheet, both the European Central Bank and the Bank of Japan were pursuing open-ended programmes of asset purchases, and the Bank of England actually increased its intended stock of assets by £50bn in August. Global central bank balance sheets were rising by about 2 percentage points of GDP per annum – a similar rate to that seen since 2012.

Some commentators argued that the central banks would never step aside from their programmes of balance-sheet expansion. After QE1, 2 and 3, we would get “QE infinity”. Others argued that unlimited quantitative easing would result in disaster, either through rapidly rising inflation, or bubbles in asset markets.

Neither of these dark outcomes has occurred. Instead, it seems that policy makers are moving away from QE because it is no longer effective and no longer necessary. “QE infinity” is coming to an end, not with a bang but with a whimper. Read more

As investors anxiously await the key monetary policy decisions from the Federal Reserve and the Bank of Japan next week, there have been signs that the powerful rally in bond markets, unleashed last year by the threat of global deflation, may be starting to reverse. There has been talk of a major bond tantrum, similar to the one that followed Ben Bernanke’s tapering of bond purchases in 2013.

This time, however, the Fed seems unlikely to be at the centre of the tantrum. Even if the FOMC surprises the market by raising US interest rates by 25 basis points next week, this will probably be tempered by another reduction in its expected path for rates in the medium term.

Instead, the Bank of Japan has become the centre of global market attention. The results of its comprehensive review of monetary policy, to be announced next week, are shrouded in uncertainty. So far this year, both the content and the communication of the monetary announcements by BoJ governor Haruhiko Kuroda have been less than impressive, and the market’s response has been repeatedly in the opposite direction to that intended by the central bank.

As a result, the inflation credibility of the BoJ has sunk to a new low, and the policy board badly needs to restore confidence in the 2 per cent inflation target. But the board is reported to be split, and the direction of policy is unclear. With the JGB market now having a major impact on yields in the US, that could be the recipe for an accident in the global bond market. Read more