The Jackson Hole Symposium goes virtual this week, highlighting just how badly the best-laid plans can go wrong, but it’s asset buying and the uncertainty of the Reserve’s interest rate policy. federal government that makes the markets nervous.
Having to bottle it up on Zoom is the least of the problems for the US Fed and its central bank counterparts, as we suggested in our FOMC minutes and Jackson Hole Outlook last week in which we looked at what it does. means for the Dollar Index (DXY – the rally in the dollar is expected to continue). The DXY is trading lower in the European session, down 0.26% to 93.257, but trading near its nine-month high ahead of the Jackson Hole meeting (see chart below).
Fed Chairman Jerome Powell has the unenviable task of hijacking the Fed from a redesigned policy framework originally designed for a world that may now disappear. This poses a problem of both message and substance.
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Inadequate policy framework: the Fed must fight inflation, not deflation
Here’s the catch: tackling unemployment while allowing inflation to exceed the target rate of 2% for a short time seemed like a sensible approach to tackling the specter of deflation, but not anymore.
After all, inflation had remained stuck at stubbornly low levels for an unprecedented period, which was the perverse result of the equally unprecedented free money policy in the aftermath of the 2008-9 financial crisis, with interest rates kept close to zero (and in some cases negative) for an inordinate period of time.
Japan has had a lost decade precisely because of the build-up of deflationary pressures in its economy and the excessive savings it has encouraged – why spend today if prices will be lower in real terms tomorrow? As you can imagine, there is a risk that deflation will become a killer of economic growth.
In such an environment, inflation became the right fit – the Fed focused on how to get it to a level where it was neither too hot nor too cold.
But today, as we have noted, the world is very different. Far from inflation slightly above the target rate of 2%, it is now more than double the rate at 5.4%. And despite the Fed’s mantra that the general price hike is transient, there are signs it could be anything but.
So this is the first problem that the Fed and the other bankers are going to grapple with: how to get the message to the markets that says something like: “our new framework was not bad but we think it needs to be adjusted quite radically ”.
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Fiscal expansion risks fueling inflation through employment targets
The second part of the Fed’s framework concerns unemployment. We had gotten used to central bankers – after the financial crisis – obsessed with inflation. In the 1970s, it was about using interest rates proactively to prevent the economy from overheating and inflation soaring.
Central bankers were marked by the experience of the 1970s and early 1980s, when the danger of falling behind inflation could force the hand of central bankers so that they had to raise rates considerably, risking harm to the economy.
Not anymore. The US Fed’s 2020 framework set the goal of achieving sustainable full employment. Clearly, the pandemic shock was the kind of Black Swan event that shook the thinking of policymakers, and the deep losses in the labor market are still being repaired. However, there is no doubt that the economy is running at full speed, even though employment is still 7 million below pre-pandemic levels.
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But the government’s response to the pandemic – in terms of scope and scale – likely also took the Fed by surprise.
The Biden administration has thrown nearly $ 2 trillion into the economy, assuming the infrastructure bill passes. And there is still $ 3.5 trillion of tax infusion to come if Democrats are successful – although that is by no means certain.
So in addition to the $ 120 billion in ongoing asset purchases, the economy is also grappling with a gigantic fiscal pump of government spending. The effect of this spending will surely be to speed up the rate at which the Fed meets its employment targets for the economy, even if the Delta variant temporarily disrupts that progress. Or at least, that’s the Fed’s hope.
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Increasing supply chain bottlenecks – higher inflation, threat to recovery?
But Delta variables aside, supply chain bottlenecks are piling up. The issues of shipping logistics are well known, as is the shortage of chips – both of which are driving prices up. A new driver of inflation on the scene is the shortage of labor in a growing number of sectors, and of skilled and unskilled labor.
There will be a lot more economic data this week on the state of the US economy, which should give more flesh to the nature of these supply restrictions.
Today we have the PMIs for most major economies including the United States, Tuesday sees new home sales in the United States, Wednesday sees US durable goods, Thursday sees US GDP growth plus demand for housing. ‘Jobs and Friday’s US PCE Core Price Index, and the final reading on consumer sentiment from the University of Michigan, with Fed Chairman Powell giving a speech to close the week – and of course the Jackson Hole Symposium Thursday and Friday.
The market needs to prepare for the end of asset purchases and rate hikes next year
Forex traders and others in the market should brace themselves for waiting for hints from Jackson Hole about a decoupling of the rate cut and hike schedule. Related to this, we should also be prepared for the reduction to start as soon as possible and, third, for interest rates to perhaps start rising by the end of 2022.
If any of these three elements are seen as coalescing in the collective mind of the FOMC, as shown by the Jackson Hole perspective offered to us this week, then that signals bad news for risk sentiment.
Last week we saw how fragile the sense of risk was in the initial response of equity markets to the FOMC minutes which showed a majority in favor of an early cut and the signal that the goal of inflation had been reached.
On this last point, it is what was missing from the minutes which emerges because of course the inflation objectives were exceeded to the point of having no relation to the objective. In this sense, the inflation target was not met because the Fed failed to keep inflation just above 2%.
Traders will also need to keep an eye out for the divergence between European Central Bank and Fed policy, with little discussion of slowing interest rate asset purchases from the ECB and inflation to 2.2%. in July – far from the US rate but heading north (compared to 1.9% in June).
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Dangers of an inverted yield curve as US Treasury market anxiety rises
Finally, and in many ways most importantly as Jackson Hole looms, the US Treasuries market is seeing spreads widening, a sign of low liquidity. Granted, this is in part because traders are on the beach, but some fear this may also reflect an increase in risk aversion, with the bond market acting in a way that has pissed off traders.
On the reasons for this, Guneet Dhingra, head of US interest rate strategy at Morgan Stanley, told the Financial Times: “The first is that we are in August and volumes are generally lower in August. August ? the markets have become somewhat confusing for investors and people have a higher degree of risk aversion.
Although inflation expectations are high, yields on US Treasuries have fallen when they normally should have risen. However, buying bonds (yields fall when bond prices rise) reflects the uncertainty of investors as they seek safe havens, even as stock markets are trading at record highs.
With the likes of Mike Burry from The Grand Court Betting the prices of long-term US Treasuries are on the verge of falling, nervousness about the future direction of policy reflects the concerns highlighted in this article.
ING analysts Antoine Bouvet, Benjamin Schroeder and Padhraic Garvey, focusing on the yield curve and the possible danger of reversal (where longer-term rates are lower than short-term rates – a very reliable predictor of recessions ), argue that the Fed needs to move more aggressively on tapering.
“If ever the Fed wants to be able to raise its key rates again without risking a premature inversion of the yield curve, it might be advisable to prepare in advance the bases for a steeper curve. Tapering could be such an opportunity, especially if the Fed insists more clearly on decoupling the timing of tapering from the timing of the first rate hikes. “
They might be right, but setting that ground in a way that doesn’t crush the stock markets could be very tricky. Although stocks are not in the main framework objectives of the Fed, they would fall within the framework of maintaining “orderly markets”.
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