Stephen Miller
Aggressive 75bp increase in the policy rate; Aggression reinforced through ‘dot plot’
In a clear signal of its determination to vanquish inflation the Federal Reserve’s FOMC increased rates by 75bps to 1.75%. The move comes after Fed Chair Powell pushed back on 75 bp increments in his previous post-FOMC press conference. However, in the wake of May CPI figures showing headline inflation at 40-year highs such a move was widely anticipated by financial markets.
In so doing the Fed signalled, via a revised ‘dot plot’, a more aggressive approach to policy rate increases than it had previously countenanced. That revised schedule of policy rate increases, however, simply better aligns the Fed with prevailing market expectations of the pace of policy rate increases.
The newly issued Fed ‘dot plot’ revealed that the central tendency now has a policy rate of 3.4% by end 2022 and 3.8% by end 2023 (compared with 1.9% and 2.8% back in March). That should not have been unexpected given that magnitude, persistence and momentum in inflation has consistently surprised the Fed.
GDP and unemployment rate projections lowered; Inflation projection revised marginally upwards
The median projection from the Fed for its preferred core PCE measure of inflation is now 4.3% in 2022 and 2.7% in 2023, up from the 4.1% and 2.6% forecast in March, although it does reflect the sharply upwards revised policy rate projection.
Fed projections for both real GDP and unemployment for end-2022 were 1.7% and 3.9% respectively (down from March forecasts of 2.8% and 3.5%).
Additionally the Fed signalled that it may hike by a similar amount at its next meeting in July with Fed Chair Powell saying that “either a 50 basis point or a 75 basis-point increase seems most likely at our next meeting,” although he added that he did not expect 75 bp increments to be “common” and that the FOMC would make “decisions meeting by meeting”.
In addition, the FOMC will continue with quantitative tightening (QT) by allowing its holdings of Treasury securities and agency debt and agency mortgage-backed securities to decline in June at the pace announced back in May (na initial combined monthly pace of $47.5 billion, stepping up over three months to $95 billion).
Real fed funds rate and real 10-year bond yields are some distance from restrictive
Financial markets are currently implying a nominal policy rate in line with the ‘dot plot’, around 3.4% by year-end and close to 3.8% by mid-2023. That is down a touch from that prevailing before the FOMC announcement.
If I have a misgiving it might be the inflation forecast will again prove optimistic.
Even on the benign Fed projection of an inflation rate at 2.7% by end 2023, the real Fed Funds rate would be barely at levels regarded as “restrictive”.
If, as looks more likely, inflation is “sticky” and declines only grudgingly toward 3%, those implied real policy rate levels start to look a bit short of being restrictive.
This suggests that the actual policy rate may need to increase further than the Fed and markets are currently projecting in order to achieve the Fed’s inflation projection. This may see a federal funds rate above 4%.
It may well also see 10-year bond yields above 4%.
Real bond yields – both trailing and prospective – while some way off the their trough, are still quite low in a historical context. As with the Fed Funds rate, in a period of stubbornly high inflation, it is not clear that the current level of real bond yields will be sufficiently restraining.
And despite recent equity market turmoil, the ‘Fed put’ still looks to be out of the money. Arguably the recent downdraft in global equity markets was ‘the downdraft we had to have’ post the extraordinary levels of monetary accommodation that accompanied the pandemic.
Indications of ‘stickiness’ in inflation
There are troubling indications that inflation may well exhibit such “stickiness”. Sophisticated measures of ‘underlying’ inflation (such as the Cleveland Fed median and trimmed-mean measures) show stubbornly elevated inflation. Such 3-month annualised measures of the ‘inflation pulse’ are above 6.5% (above 7% in the case of the trimmed-mean measure).
It must be said, however, that the Fed’s favoured measure of core PCE is running about a percentage point below core CPI which gives some credence to the Fed’s “optimism”.
Has a policy mistake already been made?
A large part of what the Fed is engaged in reflects the policy missteps of 2021.
Through a demonstrated complacence about the magnitude and momentum in inflation through 2021 the engineering of a “first-best” solution got beyond the Fed. Having let inflationary expectations escape the realm of being within their ability to comfortably manage without a serious risk of a substantial growth dislocation, it finds itself in the realm of “least bad” approaches. In other words charting a course between reining in destabilising inflation without causing a substantial growth dislocation.
History is not replete with Fed successes when faced with similar challenges in the past.
However, by recognising the earlier misstep and charting a new course it has improved the chances of achieving a “second best” outcome.
It is more difficult to make that assertion in the case of the ECB or BoE where “nth best” solutions unfortunately beckon (see below).
Markets respond positively; Is it durable?
Despite some misgivings on my part, markets responded positively to the news. Bonds and equities rallied while the USD depreciated. I have my doubts that any of these moves represent a durable trend.
Volatility is likely to remain elevated and the USD seems a safer place over the medium-term than either EUR, GBP and even JPY ahead of central bank meetings in those jurisdictions.
ECB convenes an emergency meeting to reconcile apparent incompatibility of monetary policy aims
Assesses “vulnerabilities” in the Euro-area economy
It was only last Thursday that the European Central Bank (ECB) met. At that meeting it decided to finally end pandemic-era “emergency” bond purchases and tentatively signalled two 25bp policy rate increases in July and September.
Meanwhile most other developed country central banks have already commenced policy rate lift-off and have mostly decided that an accelerated path to neutral or above via policy rate increments of 50bps or more is the appropriate course.
Those accelerated paths are in part a reflection of the failure of those central banks to recognise the persistence, momentum and magnitude of the inflation challenge. However, having recognised the problem of their tardiness in combatting inflation they have embarked on a program of attempted rectification.
ECB has only just exited “emergency” settings despite dire inflation figures
The ECB, however, has only just ended pandemic era “emergency” levels of monetary stimulus!
In an era that has been characterised by laggard central banks, the ECB is the poster child when it comes to a failure to appreciate the persistence, magnitude and momentum of inflation.
In part that reflects the curse of “institutional inertia” that afflicts pan-European decision-making on everything from fiscal transfers to Russian sanctions. (But not, it appears, antipathy toward the UK and Brexit.)
European inflation numbers are immensely troubling. The May Harmonised Consumer Price Index (HCPI) came in at 8.1 per cent, four times the ECB’s 2% goal.
This is from a central bank whose mission statement asserts that “price stability is the best contribution that monetary policy can make to economic growth.”
Europe faces a circumstance where the inflation genie looks well and truly out of the bottle and with an accompanying massive squeeze on real incomes, the threat of stagflation is a clear and present danger.
All central banks are in the process of attempting to execute a high wire act: charting a path between getting inflation back toward target without tipping the economy into recession.
ECB policy challenges are greater than most other central banks
The ECB’s challenge is more than that. It is the central bank version of a ‘death defying act’.
Not only does it need to chart the same “high wire” path but has the added difficulty of doing so without seeing borrowing costs faced by heavily indebted member nations rise to levels that call into question their ability to adequately service that debt – so-called “fragmentation”.
The blowout in Italian bond yields in the last week underscores the problem.
On Wednesday, the ECB convened an emergency meeting to discuss what it called “vulnerabilities in the euro-area economy which are indeed contributing to the uneven transmission of the normalization of our monetary policy across jurisdictions.”
Purportedly the ECB is planning to apply “flexibility” in reinvesting redemptions coming due in the portfolio of bonds it accumulated during the pandemic.
Fundamental incompatibility of monetary policy aims
In other words, it is contemplating a diminution of its undertaking at last week’s meeting to bring to an end pandemic era monetary settings – to “normalise” yields .
Unfortunately for the ECB this will necessarily come at the expense of its stated goal of “price stability”.
In my view there is a fundamental incompatibility between the twin tasks of raising (“normalising”) borrowing costs to combat runaway inflation, while at the same time also keeping a lid on borrowing costs for the bloc’s most indebted members.
Rather than chart a course, the ECB is caught between the proverbial rock and hard place: debilitating inflation or deep recession and European debt crisis 2.0.
The particulars of the course adopted by the ECB will reflect a balancing of interests – if such a balance is obtainable – between the “frugal” North and the “profligate” South.
That will take a deftness of diplomacy that will test even Christine Lagardes’s undoubted skills.
Wither the Euro?
It seems inevitable that once gain the economic viability of the Euro-project will again come under some stress.
In recent weeks the JPY has plumbed quarter century lows against the USD as the incompatibility of the Bank of Japan’s 10-year JGB target and a desire to arrest the JPY’s depreciating trend became apparent.
Incompatible aims in monetary policy attempted by the ECB (albeit of a slightly different form to that faced by the BoJ) could also see the EUR plumb new depths.
Anyone for a 2022 “parity party”?
Bank of England: summer prevarication a harbinger of a(nother) winter of discontent
BoE prevaricates as other central banks act; Only 25 bp hike expected
The Old Lady of Threadneedle Street is confused.
The memories of the ‘Winter of Discontent’ of 1978-79 have been extinguished. Forgotten is that the “discontent’ was in part spawned by a tardy response to the then growing inflation challenge. That period presaged the end of the Callaghan Labour Government and ushered in the Thatcher era.
Which brings us to the present.
Like other developed country central banks the current Bank of England was tardy in recognising just how great a challenge inflation would prove for monetary policy. By increasing the policy rate only 25 bps today the BoE, in my opinion, just gets further behind the inflation curve.
By failing to confront destabilising inflation now it risks an even greater dislocation down the track.
Unlike a number of other developed country central banks it has exhibited a stubborn refusal to alter course as the nature of its initial policy missteps become more starkly evident. By allowing inflation and inflation expectations to escape the realm of being within their ability to comfortably manage without a serious risk of a substantial growth dislocation, all central banks finds themselves in the realm of “least bad” or “second best” approaches.
Many central banks (The Fed, The Bank of Canada, the RBNZ and latterly the RBA) appear (albeit late in the piece) to have learned the lessons from 70s style inflation: viz, that delaying any aggressive response only heightens the risks of more substantial macroeconomic dislocation down the track. It is not an easy task charting a course between vanquishing inflation without tipping the economy into recession. History is not replete with central banks executing that task successfully. But having already made the mistake of underappreciating the inflation challenge, the best course now is to respond with aggression and fortitude.
If its (somewhat confusing) communication is any guide, the Bank of England has not learnt that lesson. It continues to prevaricate in its approach, having already dialled down the level of urgency it appears it wants to apply to the task at hand. Indeed, it appears to have adopted the highly risky approach of letting a squeeze on real incomes become the “cure” for a diminishing of inflation. That process is likely to prove a more elongated and painful approach than an expeditious shifting of policy rates to neutral levels. After the ECB, the BoE is the poster child for a reluctance to engage in any meaningful shift of historically accommodative monetary settings to reflect the inflationary post-pandemic realities.
As stated, I expect tonight’s meeting will deliver only a 25 bp adjustment to the policy rate to 1.25%. Given current inflation at circa 9% with limited prospects of any near-term decline this means that in real terms the policy rate is a long way from neutral let alone restraining. Unlike other central banks (the ECB aside) who are looking at “second-best” outcomes, the BoE is looking at an “nth best” outcome and “n” is way bigger than two.
Such an outcome is a harbinger for further pressure on Sterling, particularly against the backdrop of ongoing complications with the Brexit deal negotiated with the EU.
BoE Governor Bailey defends approach
BoE Governor Bailey has defended the BoE against charges that the Bank had been slow to respond to inflation challenges. He asserted that price increases were almost exclusively driven by supply shocks that couldn’t have been anticipated and that in any case it was “well established practice to accommodate supply shocks where they’re expected to be transient.”
In my view those comments are at the very best contestable and at the very worst they are egregiously naïve for a senior central banker:
- For one thing, the BoE (like other central banks) clearly misjudged the persistence magnitude and momentum in inflation.
- In its assertion that price pressures were exclusively “supply driven” the BoE downplayed the impact that its own extremely accommodative monetary stance had on inflation. This was a point made by former BoE Governor Mervyn King who claimed all developed central banks had kept monetary policy too loose for too long. The supply-side narrative downplays the reversal of structural currents that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (after the fall of the Berlin Wall and the ‘export’ of labour from large emerging market economies such as China and India), baby boomer workforce participation. Other factors such as de-globalisation through protectionist measures and re-regulation are also relevant.
- BoE communication has been inconsistent seeming to swing between the need to adjust policy to meet the inflation threat and denying a pressing need to tighten policy in a probably misguided attempt to influence market pricing of likely policy rate increases.
- Finally, it is not “well established practice to accommodate supply shocks”. The notion of transitory inflation is that it doesn’t change wage and price setting behaviour. But there has been evidence for some time that these behaviours are changing. Even if it cannot influence supply levers in the economy, by failing to incorporate supply shocks in its monetary policy framework, central banks can magnify and perpetuate the inflationary damage such shocks can inflict. This is a key lesson from the 1970s.
Bailey asserts BoE “helpless”; The British public may think “hapless” a better description
In comments that arguably further confuse markets about the BoE’s approach, Bailey last month told a parliamentary committee that he felt “helpless” in the face of global price pressures, warning of an “apocalyptic” surge[1] in the cost of food. He added that he has “run out of horsemen” after the pandemic and the war in Ukraine.
That comment comes as close as I can recall to a central bank chief saying he can’t (or won’t?) tackle inflation.
In that context is it surprising that according to a survey by the BoE itself, public satisfaction with the job the BoE is doing in containing inflation is the lowest on record. Probably not unrelatedly, the public is the most pessimistic about inflation on record, with 59% of UK citizens asked in as survey expecting prices to remain above 2% over the long-term, while more than a third think inflation will hold above 4%.
A(nother) ‘winter of discontent’ may well follow the ‘summer prevarication’.
Coming up: Bank of Japan; Australian labour force
Bank of Japan
It has been some time since the Bank of Japan managed to capture any focus but with the JPY approaching its lowest value against the USD in almost a quarter of a century and the BoJ battling to hold the line on its yield curve control target for the 10-year JGB.
Coming into the meeting the Banks upper limit for the 10-year JGB was 0.25%. Through massive intervention in the bond market the BoJ has managed to more or less maintain the target but only by allowing a massive depreciation of the JPY as rapidly rising bond yields elsewhere in the developed world surged further ahead of JGBs.
Growing discomfort with the falling JPY in some quarters of officialdom, as well as among some Japanese corporates has led some to suggest JGB yields may explode higher.
Central bank chief Kuroda has tempered his previous comments that suggested that the currency’s weakness was generally good for the economy.
However, short of abandoning the target (as the RBA was forced to do in the case of its 3-year bond target late last year) it is difficult to see what might arrest the ongoing JPY weakness,
Australian labour force
The Australian May labour force data to be released today are likely reflect an ongoing tightening in labour market conditions. Consensus expectations are for an increase in employment of circa 25k and a further one tenth decline in the unemployment rate to 3.8%, an unemployment rate not seen since the early 1970s.
Such outcomes suggest labour markets are very tight. There is evidence of wage acceleration with the latest NAB business survey revealing that labour costs continue to increase at a healthy clip. It is somewhat of a puzzle that the strong NAB survey numbers are yet to be reflected in the official numbers but most forecasters expect that an acceleration will certainly show up in subsequent statistical releases of both the Wage Price Index and National Accounts average earnings numbers. In his Statement following the 50bp increment in the policy rate, RBA Governor Lowe noted significant labour market tightness with the unemployment rate at 3.9 per cent being the lowest rate in almost 50 years and further that the RBA “business liaison program continues to point to a lift in wages growth from the low rates of recent years as firms compete for staff in a tight labour market.”
A number close to the consensus forecast is likely to reinforce current market expectations of an aggressive RBA.
Governor Lowe’s 7.30 Report appearance on Tuesday where he articulated an RBA forecast inflation rate of 7% a and a suggestion that the RBA will do “what is necessary” to curb inflation underscores RBA aggression.
That suggests that its recently acquired hawkish stance looks set to continue and that a further 50 bp hike may come in July.
By Stephen Miller, investment strategist
———