Explicit messaging is the new order of the day – but only to a point
There was a time, not so very long ago, when language used by central bankers was almost entirely cryptic. An entire cottage industry was devoted to reading the tea leaves whenever a Chair of the Federal Reserve had said this or that.
Those days are past; central bankers are keen that there should be no misunderstandings. Even so, Jerome Powell’s speech after the Fed meeting at Jackson Hole, Wyoming, at the end of August was startlingly unambiguous.
“My remarks will be shorter, my focus narrower and my message more direct,” began the Fed chair, before going on to say: “Restoring price stability will likely require maintaining a restrictive policy stance for some time.”
This would necessarily involve “some pain to households and businesses” but “we will keep at it until we are confident the job is done”, he said.
A decade ago, Mario Draghi, also eschewing the gnomic option, said that the ECB would do “whatever it takes” to keep the embattled eurozone together. This was Powell’s Draghi moment.
“It was an unusually brief speech, deliberately I think, so not as to obscure the points he wanted to make. He said, in essence, that they will pay the price to get inflation down. It was short and sweet – though not so sweet for markets,” said Steve Englander, global head of G10 FX research and North American macro strategy at Standard Chartered in New York.
Until Powell spoke, the market had been divided on whether the Fed would up rates 50bp or 75bp in the September meeting. The bookmakers are now no longer taking bets on the 50bp path. A hike of 75bp would be the third three-quarters of a percentage move in the last three meetings.
The first 75bp hike in June raised a few eyebrows, coming after 50bp and 25bp moves, but now 75bp no longer occasions surprise. Anything less would.
His speech immediately shaved 1,000 points off the Dow Jones Industrial Average, while the S&P 500 lost 250 points in the month of August. Meanwhile, volatility has returned to the Treasury market.
The two-year note sold off 50bp in a month from 3.10% to 3.60% at the beginning of September, while the 10-year sold off from 2.80% to 3.33%. “We’re back to 1970s volatility, which virtually no one in the market has ever seen,” said Englander.
What appears clear is that the Fed is willing to tip the US economy into recession to achieve price stability. That is the tax Powell is prepared to pay. How deep and how prolonged the recession will be, however, is far from clear. There are some that believe that the worst of inflation is behind us already and that some of the issues that bedevilled the economy for the past year – such as interrupted supply chains – are beginning to sort themselves out.
Half full, half empty
“We think we’re past the worst of this inflation episode – viewed either from PCE or CPI, core or headline, year-ago or sequential, and that inflation outcomes should gradually move lower,” said JP Morgan’s chief US economist Michael Feroli, speaking in the second half of August.
If this is the case, then the recession need not be that prolonged or painful. That is the glass-half-full theory.
But even if lower energy prices and falling real wages could push real inflation below 4% and perhaps to 3% over the next year, it is still likely that that a hard, resistant core of inflation will remain. If the Fed really wishes to reduce inflation to 2% or thereabouts and will brook no compromise, then a lengthier period of low rates and a deeper recession will be needed. That is the glass-half-empty theory, and it looks more compelling.
In fact, inflation breakevens suggest the expected 12-month rate one year hence will be higher than that over the preceding 12 months. Expected 12-month inflation two years out is even higher. Seemingly, the markets are sceptical that the Fed can get rid of it all that easily. While the recent sharp drop in breakevens reflected the drop in oil prices, core inflation is expected to remain above target.
The US economy might indeed already be recession – and whether or not it is has been a matter of some heated controversy lately. President Biden’s claims that even after two quarters of negative GDP growth the US economy is not, in fact, in recession has elicited a derisory response from his opponents.
But the political mood music obscures the realities. In spite of lower growth, the job market does remain very hot. Some 315,000 new jobs were added to the nonfarm payroll in August, following a 526,000 increase in July.
“It is difficult to say that we’re in recession with the third lowest unemployment rate in American history. A number of large US retailers have recently reported making progress in adjusting inventories to today’s consumer needs,” said Bill O’Donnell, senior US rates strategist at Citigroup in New York.
This seems to be the consensus view, but does not alter the fact that recession is looming large on the horizon even if it is not here yet. It is seemingly the inevitable concomitant of the Fed’s now single-minded and remorseless drive to achieve price stability.
What is making the pain even more acute is that the Fed was very late in recognising the clear and present danger of inflation, so that now it is now forced to make up for lost time. If later generations exhume Jerome Powell’s body they may well find the word “transitory” written on his heart, as Mary I of England said of Calais after the last vestige of Henry V’s French conquests was lost.
The delay has made the hikes higher and more concentrated than if the Fed had been quicker off the mark. The mistake extends not only to monetary policy but also to a much more prolonged quantitative easing than should have been the case. The tapering of US$80bn of Treasury purchases and US$40m MBS purchases, initiated to rescue the economy from Covid in March 2020, only began in December 2021 and was not concluded until March of this year.
“Looking back, where did the Fed go wrong? Probably in maintaining forward guidance and not ending balance sheet expansion in 2021 when it was clear it wasn’t needed any more,” said Englander.
It is also instructive to read some of Chair Powell’s comments at the November 2021 announcement of the beginning of tapering. The Fed's stance will remain "accommodative", he said, and it would still seek to keep interest rates near zero. The recent uptick in inflation was as a result of, he opined, "supply constraints and bottlenecks".
That opinion now looks particularly ill-judged. There is plenty of blame to share around, of course, and while central bankers should not escape scot free, neither should governments. The US$1.9trn stimulus package, which included US$1trn for households, was unveiled in the first weeks of President Biden’s four-year term, at a time when the US economy was already showing signs of a much stronger-than-expected recovery from Covid-19.
“I was concerned by the stimulus package at the time. I thought this will go directly to consumption and to spending. It was more than was required to close the output gap. It was a disaster and we’re paying the price for it now,” said one economist.
The price will be recession and unemployment. The latter is a necessary, and indeed required, concomitant of the Fed’s war on inflation. Unemployment often proves much more difficult to run down than run up, and with it comes a host of social ills that Americans have not seen for a long time.
This is the part Jerome Powell is not quite so explicit about. This new age of clarity only extends so far, of course.
EM repercussions
But what happens within the country itself has repercussions far beyond its borders. A mild US recession is already priced into a lot of emerging markets, and this might be very good for some of them. Currencies are weak while real rates are high, which could and should precipitate overseas investment.
“When I look at real rates and foreign exchange valuations, it reminds me of the early 2000s. The carry trade is back in vogue,” said Drausio Giacomelli, head of emerging markets research at Deutsche Bank in New York.
So, 2023 could be a good year for emerging markets if the US recession is mild. The LatAm region should be a big beneficiary despite the usual political risks. Brazil goes to the polls on October 2, with polls currently split equally between incumbent Jair Bolsonaro – unhelpfully dubbed “The Trump of the Tropics” – and leftist hero Luiz Inacio Lula da Silva.
There has been a spate of left-wing victories across Latin America lately, so the outcome of this election will be watched closely. Bolsonaro is seen as more markets-friendly than da Silva, and as Brazil is the US’s largest trading partner in the region, his victory may well be welcomed by the Biden administration – though not publicly, of course. Once again, clarity clearly has limitations.
Elsewhere, Turkey is thought “too big to fail” despite ongoing woes, while Asian economies offer a traditional safe haven. South Africa is also thought to offer favourable dynamics to the overseas investor despite horrendous political ills.
But this relatively rosy outlook is dependent on the US recession being relatively benign and short-lived. There is considerable tail risk. A deeper and more prolonged recession will affect all emerging market economies harshly.
“There is significant risk of recession in the US. There is sizeable leverage in the system. It is possible to see the ghosts of 1973,” said Giacomelli.
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