The Fed’s pre-emption function

Key points:

  • The Fed is not taking chances with the cycle
  • What the ECB is saying: who to believe on expected inflation
  • Germany: labour dynamics are key


The Fed is not taking chances with the cycle

Jay Powell chose to accentuate the negatives at his House Committee hearing. He downplayed the strength in the latest US GDP print and focused on the slowdown in business investment. The risks to the outlook were described as “increasing”, suggesting the FOMC was not impressed by the fragile truce on trade negotiated with China at the last G20. Powell did not qualify the below-target pace of core inflation, choosing not to downplay this by highlighting one-offs.

The Fed is definitely in a cutting mood.  Powell concluded the “monetary policy” section of his statement with the points that inflation pressures remain muted and uncertainties continue to weigh on the US outlook. This came immediately after repeating that “many FOMC participants saw that the case for somewhat more accommodative monetary policy had strengthened” at the June meeting already. Such juxtaposition suggests Powell did not want to stand in the way of the market pricing a cut for July.

In principle, the Fed could take more time. Indeed, at the moment the current monetary policy stance is not restrictive. Judging by the FOMC’s median “dot” for the long-run policy rate, at 2.25-2.50%, the current Fed Funds target is neutral. This is very different from “end of cycle” policy configurations in which Fed Funds have been brought well above the neutral rate so that the central bank has to embark in a race against time to bring its stance back into accommodative territory in a way that is commensurate with the economic downturn. Why is it then that Powell already has his finger on the trigger?

The loneliness of the last shooter. We have been arguing since the first issue of Macrocast that Powell’s pre-emptive approach stems from the fact that monetary policy, and specifically US monetary policy, is the “only game in town”. With a deficit of 4.2% of GDP and a divided Congress, counting on any additional fiscal stimulus would be risky, and the other major central banks have limited arsenals.

The Fed and the market’s expectation loop. Of course, Powell may want to trade “speed” against “magnitude”: by acting pre-emptively he can argue that he won’t be forced into massive cuts down the road, and the “somewhat” qualifier for accommodation is quite telling from that point of view. Actually, even after this week’s Fedspeak we still expect only two cuts. We have merely brought them forward, to July and September.  A problem though is that the market may get addicted to the new Fed “pre-emption function” and price more accommodation even with very little further deterioration in the dataflow. There is a real risk the Fed is getting in a complex loop with the market (the Minutes of the last meeting mention the curve inversion several times).  “Speed versus magnitude” is a very fine stance ex ante. It is very difficult to hold ex post, unless the Fed is ready to disappoint the market at some point. “Speed versus magnitude” often ends up in “speed AND magnitude”.

The Fed and the US administration loop. It is probably unfortunate that the Fed is being so dovish at a time when it is under explicit pressure to cut by the US President. However, in our view a central bank should not take the risk of triggering a downturn and hence failing to comply with its mandate for the sole purpose of asserting its independence, as long as there is no conflict of objective. While the market reacted to the slightly higher than expected June core CPI print this week, we think that the core PCE metric – crucial for the Fed – will remain below target.

However, it is also true that the Fed is at the moment an “enabler” of Donald Trump’s policies. Monetary policy is endogenous to the risks the US is generating for the global economy, not purely reactive. With “cover” from the Fed the US President can maintain a very aggressive stance on trade, and we have seen that this week again with the US administration investigating France’s decision to tax Gafas, raising the possibility of retaliation on French exports to the US.


What the ECB is saying: who to believe on expected inflation? Markets vs households

With Powell validating the market’s pricing of early action by the Fed, pressure is rising further on the ECB to deliver a depo cut, as also priced by the market. We are no big fans of such moves but a bout of FX appreciation is probably the last thing the Euro area needs right now.

So a July cut by the Fed raises the probability of a September cut by the ECB, pre-announced by a change in forward guidance at the end of the month. Still, given the risk of retaliation via trade if – as is likely – the US administration sees a depo cut as currency manipulation, the actual floor for the policy rate may be higher than the “absolute” technical floor (probably around 1%). Faced with these limitations to the depo rate, the ECB would normally be inclined to roll-out QE again, and we have seen a flurry of conversions to such baseline in the Street literature this week.

Still, the bar for resuming QE may be higher than the market is currently pricing. We have been quite intrigued by a speech by Benoit Coeuré released on 11 July on “inflation expectations and the conduct of monetary policy”.

Coeuré seems to downplay the deterioration in market-derived inflation expectations. His point – which is not altogether new – is that 80% of the recent steep decline in 5y5y inflation-linked swap merely reflects a drop in the risk premium, or, as he explains in plain English himself, “ while expectations of a surge in the euro area demand and inflation….have been significantly cut, expectations about the baseline have remained more stable”. It is only at shorter maturities that inflation-linked swaps genuinely reflect a decline in the baseline. This would be reassuring for the ECB’s credibility, since its definition of price stability is on a medium-term horizon.

Coeuré went further by looking at survey-based inflation expectations. He made the point that expected inflation derived from household surveys are a better predictor of firms’ actual pricing behaviour than market-based measures. Since households’ views of inflation are more stable than market-based ones – and have remained more resilient recently - this allows Coeuré to argue that the “de-anchoring” of inflation expectations revealed by the linkers provides a distorted picture of reality.

This matters for policy-setting. All this may read like a particularly nerdy debate for specialists. But market-wise one sentence in the speech is particularly interesting in our view: “unlike the situation in late 2014 and early 2015, when inflation expectations fell sharply across the population, and when we launched the asset purchase programme, today households are much less sceptical about the future”. We think this means that he is for now unconvinced the central bank should “naturally” resume QE, even if he has been happy lately to publicly consider this as an option.

Do not underestimate the political difficulties around QE. Benoit Coeure has had several episodes in the past when he distanced himself from Draghi, without necessarily winning the argument. At the moment, there is probably  a strong temptation around Draghi to “lock-in” a decision on QE before Lagarde’s arrival – so that she would have time to settle in without being immediately burdened by the fallout of controversial decisions. But for QE 2.0 to be relevant, the “limits” will have to be revisited, which is not a walk in the park. So for now we remain unconvinced that the central bank will pull the trigger “unless the outlook improves”, as per Draghi’s low bar in Sintra. It may still take the materialisation of “adverse contingencies” to borrow from Philip Lane’s words in the last council minutes.


Germany: watch the labour market

Could a “technical recession” in Germany be such an “adverse contingency”?  Relative to December 2018, industrial production in May was down by 1.4%, while it was up 3.2% in France. As we’ve already pointed out several times in Macrocast, this is not terribly surprising given the geographic and product specialisation of German industry. A crucial issue for the fate of the Euro area cycle is whether this softness “imported” from the rest of the world will spread to the domestic economy.

A strong and stable relationship between exports and GDP growth. The correlation between the change in exports and goods and that of GDP is particularly high (see exhibit 1) and stable (a rolling correlation over 5 years never returns a coefficient of less than 0.4). Since unification in 1991 we have found 7 “mini export cycles”. In 6 of these cases GDP decelerated markedly. So far, contagion has been the rule, domestic resilience the exception.

As an export-oriented, manufacturing-heavy economy (i.e volatile) with a fairly low potential growth, statistically Germany should go through technical recessions more often than a service-based, inward-looking economy. For instance, Germany had two consecutive quarters of GDP decline in late 2012/early 2013 – at the time of the contraction in European demand triggered by the sovereign crisis - which France avoided.

However, export-driven downturns have become less “painful”. These technical recessions may barely register for the public, because the labour market remained resilient. And indeed, the sensitivity of the unemployment rate to the export cycle has diminished since the introduction of sweeping labour market reforms in 2003 (see exhibit 2). Before then, a 10% drop in exports – not that unusual with a standard deviation that stands at 7% - would lift the unemployment rate by 0.7% after 6 months. After 2003, the impact on unemployment fell by nearly half (note however that fiscal support, subsidising businesses to keep workers on their payroll at the height of the 2009 crisis also helped).

Exhibit 1 

Exhibit 2


2012-2013 redux? Net job creation has only started to slow down (see exhibit 3) but so far only Q1 data is available. Still, the more timely hiring intentions (latest are for June) have already fallen below their long term average in the manufacturing sector (see exhibit 4) and are back to where they were in late 2012. Note however that at the time the unemployment rate barely rose (from 6.8% to 6.9%), as employment growth remained positive. In addition, and in contrast with 2012-2013, hiring intentions in the services sector are still healthy, even if they are softening. This may reflect the fiscal push (c.0.8% of GDP) currently at work in the German economy.

Exhibit 3

Exhibit 4

German unemployment and the political economy of the Euro area. Our point here is that, were the global cycle to remain challenging in the second half of the year, Germany would be a good candidate for another technical recession (actually it barely avoided this in the second half of last year already), but this may not necessarily change the equation for policy-makers. Indeed, if public opinion remains largely oblivious of the cyclical deterioration because of the labour market resilience, Berlin would probably still prefer to stay away from any “coordinated fiscal push”, while the reluctance for further monetary stimulus would still be commonplace.

Of course, beyond the slowdown in external demand, we think the German economy is facing deeper structural issues. Its reliance on the car industry in particular will likely remain a hindrance, while “trade guerrilla” may become a permanent feature of international relations. But it may take time to trigger the sort of change in policy preferences in Germany which would speed up the emergence of new policy solutions at the European level in the next few months.

All data sourced by AXA IM as at 21 June 2019

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