NN IP: A tale of two central banks

Yellen delivers her fifth and last hike but the Fed will go on

As we discussed last week the Fed is balancing two sets of risks: the risk of inflation remaining surprisingly low, and the risk of too much overheating in the real economy and/or an unsustainable risk rally in financial markets. The latter risks, if they materialize, will create real or financial imbalances that will correct at some point, in which case they will put the sustainability of the expansion at risk. 

Two caveats need to be made in this balancing act. First of all, the majority of the FOMC still feels that financial stability risks are contained because asset valuation can to a considerable extent be explained by the low level of r-star (real policy rate consistent with full employment and price stability) while private and financial balance sheets are less levered than they were in 2008. In short, the majority of the FOMC will thus remain focused on macro stability and does not see much of a trade-off between the latter and financial stability. This is not to say that financial conditions do not play an important role in policy setting. In fact the substantial easing of financial conditions over the past year in the face of four hikes (including the most recent one) suggests that monetary policy has eased on balance due to a modest rise in r-star from extremely low levels. 

Secondly, as far as the concept of overheating in the real economy is concerned, it is important to bear in mind that full employment is essentially an “ex post” concept. In other words, the NAIRU (equilibrium unemployment rate) is a state-dependent variable that can shift considerably over time and its true location can only be established after the fact by observing the behaviour of (wage) inflation. Such a strategy of “probing the NAIRU” can be pretty risky in an environment of above-target inflation where the risks to inflation expectations are on the upside. After all, if the Fed pushes the unemployment rate down too much, it will unleash an upward drift in inflation expectations, which can only be reversed by a costly recession induced by substantial monetary tightening. However, in the current environment of persistently below target inflation and the possibility that inflation expectations have slipped to the downside these risks are much more muted. It is precisely for this reason that the Fed already has effectively adopted the strategy of deliberately running the economy hot, relative to its own ex ante full employment benchmark summarized by its 4.6% NAIRU estimate. Still, in view of the trade-off between lowflation risks and risks to the sustainability of the expansion, the Fed still deems it prudent to slow down the pace of decline in the unemployment rate going forward. This is essentially why the FOMC continues on the gradual path towards a neutral rate setting. 

The upshot of all this is that inflation will remain a key variable going forward. As long as inflation does not accelerate markedly but drifts up gradually towards the target it is hard to see the Fed deviating from its gradual rate-rise game plan. Of course, if inflation suddenly wakes up, the Fed will probably accelerate. However, if inflation remains surprisingly low in the next few months the Fed might well slow down the pace of rate hikes. So far, the data firmly point to sticking the course. November core CPI inflation disappointed to the downside and suggests core PCE inflation will remain at 1.4%. Meanwhile, after revisions, average hourly earnings growth remains around 2.5% yoy. All in all, the behaviour of wage and price inflation remains consistent with the notion that inflation expectations have slipped a bit below 2% in our view.

The aforementioned two principles – the fact that the Fed is relaxed about running a hot economy and at the same time that it wishes to limit the degree to which it gets even hotter – were the main message from the December meeting, where the policy rate was raised for the fifth time in this cycle by 25 bps. There were two dovish dissents by Evans and Kashkari but both will be non-voters next year and will be replace by more hawkish regional Fed Presidents. The Fed expects that further “gradual adjustments in the stance of monetary policy” will be warranted. During the press conference, Yellen said this approach is most consistent with the maintenance of “sustained” strong labour market conditions.  As for the updated forecasts, the most conspicuous change was a 0.4pp upward revision of 2018 growth to 2.5%. In 2019 and 2020 the Fed expects growth to be at 2.1% and 2.0% respectively, which is not that much above its 1.8% potential growth estimate. One would expect that the large upward revision to growth in 2018 was mostly caused by the incorporation of the tax cut in the forecasts. Interestingly, Yellen downplayed this factor as she said that fiscal policy will provide “some modest uplift” to growth in the coming years. In fact she gave the distinct impression that she believes that the easing of financial conditions seen this year will deliver a bigger growth boost. We agree with this notion as the tax cut mostly increases after-tax income for wealthy actors in the economy, which means the growth impact is likely to be low. Meanwhile, the forecast for core PCE inflation continues to show a gradual rise towards 2% in 2019 and roughly staying there in 2020. 

Arguably the most puzzling element of  the Fed forecasts is that the FOMC expects the unemployment rate to trough at 3.9% in 2018  and stay there in 2019 before rising to 4.0% in 2020. Hence the trough is only 0.2pp below the December level of 4.1% even though the Fed expects growth to be well above potential in 2018 (and a bit in the following years). What’s more, long-run potential growth remains at 1.8% in the Fed’s view. The only way to square this circle is to assume that there is some temporary increase in potential growth. This could either come from an unexpected  increase in the participation rate or an upside surprise to productivity growth, both of which could well happen. Still, we see a considerable risk that the unemployment rate will dip below 3.9% next year and drift closer to 3.5% in the near term as it may take some time for the supply side improvement to come through fully. This need not be the trigger for a large non-linear reaction in inflation dynamics because we believe the NAIRU may be lower than the 4.6% estimate used by the Fed.  “Informal” labour market institutions that provide the framework for wage bargaining may well have changed a lot in the past 10-15 years due to the increased importance of flex contracts and the “gig” economy. In fact we find it hard to see why the Fed did not already lower the NAIRU estimate in the light of the lowflation data. 

In view of all this it is not surprising that the median participant continues to see three rate hikes in 2018. Having said that, the distribution of the 2018 dots has shifted a bit in a dovish direction relative to September. For 2019 the median participant pencilled in two further rate hikes. In the long run the neutral nominal rate (r-star + 2%) remains between 2.75% and 3% and the Fed expects to overshoot this level slightly in 2020. Interestingly, as far as the current level of r-star is concerned, Yellen no longer reiterated her September statement that it “zero or slightly positive”. This suggests that the FOMC may have been toying with the idea that r-star moved up a bit due to a strong feedback loop between growth and financial conditions.

An uneventful ECB press conference

The ECB sees itself faced with roughly the same dichotomy between the real and nominal sides of the economy than the US. The dichotomy is actually bigger on this side of the Atlantic, which is only normal since the European cycle lags the US by about four years and because the risk of slipped inflation expectations is a lot bigger here. The real side is surging ahead with upside surprises, especially in the confidence data but also in the hard data. An important point to make here is that the region is in the process of recovering lost ground on the growth side of the equation and still has ample room to continue to do so. 

Meanwhile, the nominal side continues to point to an underlying inflation rate that is well below the ECB’s inflation target. Core inflation fell back to 0.9% yoy and the underlying trend there is only slightly upwards. Incidentally, we have to bear in mind that the core inflation rate consistent with sustained on-target headline inflation is likely to be higher today than it was in the 2002-07 period. Back then, we were in a secular uptrend in commodity space, which kept the energy and food contributions to headline inflation consistently positive. This performance is unlikely to be repeated going forward. Meanwhile, the trend in the growth rate of negotiated wages is still going sideways while other wage growth measures display a soft hint of picking up. Still, underlying productivity growth is also improving somewhat, because of which a bit of additional wage growth is not likely to add much additional impetus to the momentum in underlying inflation.

In view of all this, it is not surprising that Draghi sent a message of continuity at the press conference. In particular, no impending change to any of the instruments was communicated. The most conspicuous element was probably the updated forecasts, in which 2018 growth was revised up by 0.5pp to 2.3% and by 0.2pp to 1.9% in 2019. Growth in 2020 is expected to be 1.7% This suggests above-potential growth for the next few years, which is why it is not too surprising that the ECB forecasts unemployment to fall to 7.8% in 2019 and 7.3% in 2020. The latter matches the low in the previous cycle. The ECB does not announce its estimate of the NAIRU but it is likely that the latter is higher than 7.3%, probably closer to 8%. First of all, we would remark that the translation from GDP growth to the corresponding unemployment rate grows ever more uncertain as we look further into the future because of the possibility that potential growth could be pushed higher by strong demand growth via an increase in the participation rate and/or an increase in productivity growth. The practical implication of this is that such positive supply side development could push the NAIRU lower. Secondly, it is interesting to note that throughout the forecasting period the ECB expects inflation to remain well below 2%. Inflation is expected to be 1.4% in 2018 but the core inflation forecast for that year was actually lowered to 1.1%. For 2019 and 2020 the ECB expects 1.5% and 1.7% inflation respectively, with inflation attaining a cruising altitude of 1.8% in late 2020. The corresponding estimates of wage growth (currently around 1.5%) show a gradual rise towards 2% in 2018/19 and then a non-linear jump to 2.7% in 2020. The interesting thing here is that the ECB’s forecasts tell us that it is planning to do the same thing as the Fed; i.e., the ECB plans to run the economy hot for a while (unemployment rate below its ex ante NAIRU estimate) to push inflation up. This is as close as these central banks are likely to get to implicitly admitting the risk of slipped inflation expectations. However, whereas the Fed is currently implementing this plan, so far it is only an intention for the ECB and it remains to be seen whether or not this intention will be carried out in the end. 

During the press conference Draghi expressed increased confidence that inflation will return towards the target in the medium term because of a strong cyclical momentum and a significant reduction of slack. Essentially he is explicitly professing his faith in the Phillips curve here. This gradual build-up of confidence in the inflation outlook will be the main signal the ECB will use to communicate the likelihood that net asset purchases will be brought back to zero over the next year or so. Still, for now Draghi staunchly defended the open-ended nature of QE. As we argued back in October, keeping this optionality fully alive is vital for the ECB’s credibility because the central bank explicitly tied the continuation of net asset purchases to progress towards price stability. 

Going forward, we expect the ECB to continue the process of gradually rebalancing across instruments, i.e., less emphasis on QE and more on rate forward guidance. Not surprisingly, the behaviour of underlying inflation will be the crucial driver of the speed of this process. Draghi singled out wage growth as especially important here. Our base case is that he ECB will announce a gradual taper towards zero between September and December 2018 around June/July provided  inflation momentum shows convincing improvement. In that case the ECB can still claim that the continuation of QE is indeed tied toward progress to price stability. The risks reside on the side of the ECB continuing purchases on a very small scale into 2019 if inflation does not pick up. The sole purpose of this would be to cement the guidance that rates will remain on hold “well past” the end of net asset  purchases.

The common thread in G3 central bank policy

As a final remark for this year we would like to leave you with these thoughts: the common theme for the G3 central banks is the juxtaposition of strong growth and soft inflation outcomes. In response to this situation the BoJ , the Fed and the ECB signal that they deem it optimal to overheat the economy to some extent, at least relative to their own ex ante benchmarks of full employment. Once again, this is as close as the Fed and the ECB are going to get to implicitly admitting the risk that inflation expectations have slipped below the target. Of course, there are large differences among the G3 central banks. The BoJ is very open about its intention to overheat and engineer a persistent if moderate inflation overshoot. The Fed has allowed this overheating to happen without explicitly drawing attention to it, and its forecasts do not incorporate an inflation overshoot. As for the ECB, all this is still very much an intention because there is still a lot of slack in the economy. What’s more, the credibility of this intention is limited in our view because the ECB hawks are willing to sacrifice anchored inflation expectations to reduce the still-limited risks of imbalances in the real economy and/or the financial system. What’s more, it is clear that many ECB GC members actually see the inflation target as a ceiling rather than a target. In our view this further reduces the credibility of achieving inflation rates “below but close to 2%” on average in the long run. At any rate it is clear that this juxtaposition of strong growth and soft inflation will be pretty important for central bank policy next year.

Emerging markets: central bank action and important political events

In times when the Fed raises rates and market participants continue to price more Fed rate hikes, pressure on EM tends to increase. This was the case in between September and December. In recent weeks, things calmed down a bit again, both for EM equities and EM bonds. Nevertheless, financial conditions have become much less easy than they were last summer. They have even started to tighten a bit recently. Our own EM financial conditions indicator just turned negative this week.

In this context it is relevant to look at recent policy action by EM central bank. In the past week, four central banks moved rates. China hiked two of its policy rates by a symbolic 5 bps. Russia cut its policy rate by 50 bps, on the back of more orthodox currency and rate management and benign inflation. Turkey hiked rates by 50 bps, less than the market was expecting. The Turkish economy is clearly overheating, which could become a big problem if global liquidity were to become tighter. And Mexico hiked by 25 bps, its first move since June. Inflation had started to move higher again and the central bank wanted to prepare itself for a prolonged period of uncertainty with the difficult NAFTA renegotiations and the July presidential elections.

On the political front, 2018 will be a year with important, possibly crucial events. In Latin America, Mexico, Brazil and Colombia will hold elections. So will Russia (we know the result), Egypt (likewise), Malaysia and Thailand (if they are not postponed again). In the past week, we had already some important political events.

State elections in Gujarat, India, resulted in a victory for national government leader Narendra Modi’s BJP party. The result was a bit less than expected, particularly in the rural areas, which can be seen as an important wake-up call for the BJP ahead of the 2019 national elections. It is likely to trigger more policy focus on the rural areas, with possibly some negative implications for the budget deficit.

In Chile, in the second round of the presidential elections, the candidate of the right, ex-president Sebastián Piñera won by 9 percentage points, a surprisingly wide margin that explains why Chilean assets rallied sharply this week. Piñera has a clear business-friendly, pro-growth policy agenda. But he will not have a majority in Parliament, which means that a sharp turn to the right that eliminates the labour and fiscal reforms of the outgoing president Bachelet is highly unlikely. So continuity of policies with a more business-friendly face is what markets have been cheering about.

In South Africa, the ANC appointed Cyril Ramaphosa as its new leader, succeeding Jacob Zuma. This gives some hope for reforms to bring South Africa back on a sustainable growth path. But in the leadership around Ramaphosa, several people from the Zuma camp were appointed, which will make it difficult for Ramaphosa to break with the Zuma past and make any quick progress with meaningful policy changes. Changes that the country will need to avoid more credit rating downgrades. The next general elections are scheduled for 2019, which means that the whole of 2018 will be dominated by the directional struggle that has characterised South African politics for a while already.