Are markets too sanguine about interest rates and inflation?


Stephen Miller

FOMC opts for another 75bps increment

In a clear signal of its determination to vanquish inflation the US Federal Reserve’s FOMC increased rates by 75bps to 2.50%. Such a move was widely anticipated by financial markets in the wake of ongoing elevated inflation figures.

Moreover, Fed Chair Powell in a press conference following the decision suggested a further rise of the same quantum was a possibility saying “another unusually large increase could be appropriate at our next meeting.” He added that that any such move would be data dependent.

While noting that the Fed would obviously slow the pace of increases at some point, Powell sought to give himself and the Board maximum optionality with regard to future moves by stating that policy would be set on a meeting-by-meeting basis rather than offer any explicit guidance on the size of the next rate move.

Powell said that he did not believe the economy was in recession, citing a “very strong labour market” as evidence. The accompanying Statement from the FOMC also implied that Fed officials believe that they can manage a so-called soft landing for the economy and avoid a steep downturn,

Powell’s comments sparked a rally in US equities, while Treasury yields fell along with the USD.

Financial markets have recently pared bets of the likely peak in the policy (fed funds) rate. They now see that rate peaking around 3.25% at year-end and imply some modest easing thereafter to around 3% by end-2023.

The Fed ‘dot plot’ issued at the June meeting revealed that the central tendency now has a policy rate of 3.4% by end 2022 and 3.8% by end 2023. Powell reiterated in his press conference that  those forecasts were the best current guide of where the Fed was heading this year and into 2023.

If I have any reservation about current market pricing it is that the inflation expectation embodied within it might prove too optimistic.

Current US 2-year break-even inflation rates (to mid-2024) are close enough to 3%.

That would mean that markets are anticipating that the “trailing” real policy rate will struggle to get above zero over a 2 year horizon. That hardly looks “restrictive”! Similarly if the nominal 10-year bond yield stays around 3% (or lower) the “trailing” real 10-year bond yield also struggles to get above zero.

This is not to say that such an outcome is implausible, but were it to occur it would mean that the cyclical peak in real rates (both the policy rate and 10-year bond yield) would be extraordinarily low both compared to history and against the background of a multi-decade high in inflation.

As mentioned, it is difficult to describe such real interest rate outcomes as “restrictive”.

The flipside is that such outcomes imply a reasonably benign adjustment path in which it is difficult to see anything other than a very shallow recession, or perhaps none at all.

The average real policy (fed funds) rate in the 60 years leading up to the pandemic was around 1.4%; for the 10-year bond yield it was 2.3%.

In the current century that kicked off with the ‘tech wreck’, and encompassed the Global Financial Crisis, the real policy rate up until the onset of the pandemic averaged minus 0.2%; for the 10-year bond yield it was 1.4%.

There might be good reasons for both measures of real rates were to peak at relatively low levels, implying a nominal rate for both the policy rate and the 10-year bond at around 3%, (e.g. historically high private sector debt levels).

But in the context of multi-decade highs in inflation such a scenario seems a bit of a challenge and it is one to be viewed with deep scepticism.

That scepticism is reinforced by what looks like an underappreciation of just how stubborn broad-based measures of inflation have been.

Measures of ‘underlying’ inflation pulse show extraordinary momentum. On a 3-month annualised basis, the Cleveland Fed measure of trimmed-mean inflation is currently running at over 8% (see chart). That sort of inflation pulse is indicative of a developing inflation inertia (last seen in the late 70s / early 80s) that may prove a lot more difficult to arrest than markets are currently contemplating.

In this context real and nominal interest rates (whether it is the policy rate or 10-year bond yield) need to go significantly higher. Both measures may need to go significantly positive in real terms implying “4 handles” in nominal terms.

That being the case there may still yet be more to play out in the battle against inflation and the likelihood remains of attendant more enduring bouts of volatility in financial markets.

The June quarter CPI inflation print, the RBA and ‘inflacency’

The June quarter inflation print seemed to provide to provide some comfort to financial markets: bond yields fell as markets pared bets on the size of the likely rate increase when the Reserve Bank of Australia (RBA) Board meets on Tuesday.

That reaction surprised me a little. It is redolent of an ongoing complacency on inflation (‘inflacency’ if you will).

While it is true that the ‘headline’ number, at 6.1%, may have been (ever so slightly) better than expectations, it was the highest annual read since December 1990. The annual rate of change in RBA’s favoured trimmed mean measure, at 4.9%, was the highest since the inception of that series in June 2003 and the highest ‘underlying inflation’ measure since the early 90s.

Both numbers are some way north of the most recently published RBA forecasts back in May of 5.5% for headline and 4.5% for the trimmed-mean.

The inflation numbers come after a blockbuster June employment report which showed a huge 88k employment gain and a further sharp drop in the unemployment rate to 3.5% (the lowest in 48 years) and a level the RBA did not forecast to be reached until mid-2023.

The June quarter CPI print also comes in the wake of June RBA Board meeting minutes that state that the level of the cash rate was seen to be “well below the lower range of estimates for the nominal neutral rate” and comments from RBA Governor Philip Lowe that the neutral policy rate was as “at least 2.5%” (my emphasis). The implication obviously being that the neutral rate is likely higher than 2.5%.

To me that means that when the RBA Board convenes next Tuesday the choice is between increments of 50bps or 75bps. Markets see it as a choice between 25bps and 50bps (admittedly with the probability heavily weighted toward the latter)

Like almost every other central bank, a late start, and an overly conservative approach to the withdrawal of historically high levels on monetary stimulus has put the RBA out of the realm of “first best” solutions.

It now finds itself searching for a “least bad” approach. Having endured its own bout of ‘inflacency’ and potentially let the inflation genie out of the bottle, it is not an easy task to chart a course between vanquishing inflation without tipping the economy into recession.

However, if there was a lesson to be learnt from the 1970s inflation episode, it is that a more tepid approach now might necessitate an even more aggressive approach down the track with an attendant greater likelihood of more substantial macroeconomic dislocation in terms of growth and employment.

In this context, if the current policy rate is indeed well below the neutral rate and there is a pressing requirement to get to neutral and maybe beyond that to “restrictive” territory, then the best approach is do so as quickly as possible. This would seem to point to a 75bp increment in August.

That would certainly go a long way to vanquishing ‘inflacency’, both in financial markets and among important economic actors.

There is an argument – not without merit – that the greater frequency of RBA Board meetings compared with their counterparts elsewhere affords the opportunity of lesser 50bp increment in August. The RBA meets monthly, as opposed to every 6 weeks like most of its developed country counterparts. A 50: 50: 50 bp sequencing of rate rises over three consecutive meetings would be virtually equivalent to a 75:75 sequencing over two consecutive meetings in other developed country central banks.

That might mean a 75bp increment in August is at this stage less likely than 50bps.

However, it is folly to rule out the larger increment. 

Coming up: US Q2 GDP; Euro area July CPI

US Q2 GDP is scheduled for release this evening. Markets are no doubt focused on whether that release would be consistent with the popular definition of a recession. Q1 GDP came in at -1.6% and while expectations for Q2 are for a small increase of circa 0.5%, the Atlanta Fed ‘nowcast’ (a running estimate of real GDP growth based on modelling available economic data for the current quarter) is running at -1.6%. Even if that popular definition is met it would not mark an “official” recession. That is determined, dated and declared  by the National Bureau of Economic Research (NBER) which monitors a range of indicators in order to ascertain whether the economy is in recession or not. A key part of those indicators relate to the labour market. It is the case that with every recession since the end of WWII, the US unemployment rate was either climbing prior to a declared recession, or it rose during the period where a recession was declared. That’s not the case in the first half of 2022. Since the beginning of the year, employment growth has been robust and the unemployment rate has fallen from 3.9% to 3.6%. No doubt the recession debate will roll on regardless of the GDP print tonight.

Euro area July CPI is scheduled for release on Friday evening. The headline inflation rate is expected to be unchanged at 8.6% while the European Central Bank (ECB’s) favoured ‘harmonised’ measure is expected to be around 8.8% from 8.6% in June, still well over 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.”

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.

At a time when most other developed country central  banks had already commenced policy rate lift-off and had mostly decided that an accelerated path to neutral (and beyond) via policy rate increments of 50bps or more is the appropriate course, the ECB had barely shifted from applying pandemic era “emergency” levels of monetary stimulus until last week when it moved the deposit rate by 50 bps to zero.

The ECB appears to be confronting a fundamental incompatibility between the twin tasks of  raising (“normalising”) borrowing costs to combat inflation, while at the same time also keeping a lid on borrowing costs for the bloc’s most indebted members, most notably Italy.  This at a time when Italy’s political circumstance is fragile and Europe confronts the spectre of an extended period of elevated gas prices as the conflict in Ukraine drags on.

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.

The ECB’s challenge is more than that. It is the central bank version of death defying.

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”.

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.

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