The Fed and other Central Banks in the Week Ahead
The Fed and other Central Banks in the Week Ahead
- • Investors seem increasingly torn between the Fed being behind the inflation curve and if tries to catch up, it will risk significantly weakening the economy. The market does not appear to have much faith in the Federal Reserve engineering the proverbial soft landing.
- • The market has about a 95% chance of a March hike and an 80% chance of a fourth hike discounted. The balance sheet is expected to begin shrinking in late Q2 or early Q3.
- • US fiscal policy is also on course to tighten dramatically this year.
- • Norway hiked rates in December, and the market has 75 bp of tightening priced into the swaps curve. It has not hiked rates at back-to-back meetings since 2015.
- • The Bank of Japan meets and no change in policy is expected this year (swaps curve), but officials may raise their inflation forecasts and trim the growth prospects.
- • China reports Q4 GDP and provides some details. It should not stand in the way of further easing by the PBOC. A small cut in the 1-year Medium-Term Lending Facility (2.95% since March 2020) is possible.
- • Canadian inflation may rise above 5%, and with a booming labor market, the odds are increasing of a Bank of Canada rate hike later this month.
- • The UK reports retail sales, employment, and CPI. The market is confident that the Bank of England will hike rates early next month.
The Fed’s hawkish turn was extended. It now seems clearer to more participants that to maximize the Fed’s flexibility later in the year, it will need to raise rates in March. With the Fed still buying bonds, albeit at a slower pace, the January 26 meeting is all but ruled out. The pricing of the Fed funds futures reflects more than a 95% chance of a hike at the mid-March meeting. The futures strip favors a hike each quarter. It has three hikes fully discounted and about an 80% chance of a fourth.
This adjustment that arguably began in September rippled through the capital markets, sending interest rates higher and equities lower. It also seemed to underpin the US dollar. However, the market may be ending this particular adjustment phase. Even with the 7% CPI, a 39-year high, the market could not extend its move. The US 10-year yield stalled near 1.80%, which incidentally is around the average of the past four years. In fact, it slipped lower after the December CPI report and finished the week little changed, slightly below 1.77%. The 10-year breakeven, the difference between the yield of the inflation protected issue and the conventional note, eased two basis points after the CPI. It is a little more than 10 bp lower since the end of 2021.
Chair Powell’s remarks at his confirmation hearings were meant to persuade the Senators (and the wider public) that the Fed would act to prevent inflation from becoming entrenched. Without adding many specifics, he lent credence to market speculation that the balance sheet would likely begin shrinking later this year and probably at a quicker pace than after the Global Financial Crisis. We have argued that turning the tap on and off quickly, like the federal government’s balance sheet, is part of the process by which QE is normalized.
The Fed has been clear that the Fed funds will be the main tool of monetary policy. Still, if the Fed begins to allow maturing issues to roll-off and reduce the balance sheet around the middle of the middle of the year, it may supplant a fourth rate hike. Meanwhile, some outspoken critics of the Fed, like the former NY Fed President Dudley, former Treasury Secretary Summers, and noted fund manager El-Erian continue their campaign about the Fed being behind the curve and making a policy mistake. Still, most private sector economists seem to agree with Powell (and Yellen’s suggestion) that price pressures will ease in the second half of the year. Of course, they do not characterize it as transitory as they did previously, but the general view just pushed out the peak in prices six to nine months.
Dudley writes that the Fed’s latest set of projections point to above-trend growth while having inflation “melting away.” Of all people, he ought to know not to use the Summary of Economic Projections like they are the Fed’s forecasts. Most regional Fed presidents do not have Dudley’s experience as an economist at Goldman. The skills needed to become a regional Fed president are often far removed from economic forecasting.
The forecasts that the individual Fed members provide are for annual growth. In his polemic, Dudley did not appear to consider the trajectory of growth. The median projection for this year is 4.0%, falling to 2.2% next year. Isn’t slowing growth a reason to expect less price pressures? The base effect will also likely help dampen the 12-month measure of inflation. In addition, there are good reasons to expect supply chain disruptions to ease. Such disruptions boost prices and ostensibly create incentives to new market entries.
There is a potential source of inflation that rarely has entered the discussions: Corporate consolidation and concentration. Reuters reports that last year, mergers and acquisitions in the US reached a record of almost $2.6 trillion and accounted almost half of all the global activity. The previous record was set in 2015 at a little less than $2 trillion. The M&A activity was widespread. There was some 20k transactions, around two-thirds more than in 2015, according to Bloomberg data. Records were set in several industries, which coincidentally are experiencing strong price pressures now, including consumer goods and industrials. Consolidation in the tech sector also reached a record.
Six months ago, Summers recognized that market concentration could spur higher prices, but more recently claimed that using antitrust to combat inflation is “science denial.” A few weeks ago Matt Stoller calculated that on the eve of the pandemic, nonfinancial corporate profits in the US were about $3081 per capita and last year reached $5207. This alone, he argues could account for almost 45% of the increase in the general price level (inflation). Moreover, it challenges the wage-push inflation narrative that has gained currency. The unvarnished truth is that the pandemic has been good for corporate profits. Market concentration can lead to pricing power directly and by rationalizing (reducing) capacity.
When Dudley was at the Fed, it is understandable that he focused on monetary policy. That was his job. But there is no reason in discussion of the economic and inflationary outlook not to mention fiscal policy. The US is beginning to experience one of the sharpest declines in the budget deficit ever. Consider that the 2021 deficit looks to have been around 12.5% of GDP. It is expected to be almost halved this year. The median private sector economist forecast in the Bloomberg survey, for whom Dudley writes, has it falling to 6.4% of GDP in 2022. Some fiscal support is already being withdrawn. Extending the enhanced child tax credit was in the Build Back Better bill, which appears to have stalled. It expired with the last checks sent out around mid-December.
After the employment and inflation reports, the week ahead for US economic data pale in comparison. The January Empire and Philadelphia manufacturing surveys may be too early to generate a reliable insight given the disruptions caused by absenteeism spurred by the Omicron. Anecdotal high frequency data warns of downside risks to these surveys. Perhaps the most substantive new information will come from the December housing starts. However, they surged 11.8% in November, the first increase in three months, and it seems more a question of how much they slowed.
As a measure of residential investment, it may help fine-tune Q4 US GDP estimates, though the dismal retail sales (-1.9%) and manufacturing output (-0.3%) will encourage a downward drift. The median (Bloomberg survey) is for 5.9% annualized growth after a disappointing 2.3% pace in Q3. The early call for Q1 is around 4.5%. Note that the World Bank cut its US growth forecast for this year by 0.5% to 3.7% from its mid-2021 forecast.
The eurozone data on tap, including the November current account and construction output, are not market movers. Still, the November trade balance (not seasonally adjusted), reported before the weekend, unexpectedly swung into deficit for the first time in early 2014. Meanwhile, the attempt to find some assurances for Russia stopped short of ruling out eventual NATO membership for Ukraine and Georgia, which keeps the threat of war elevated. Also, Italian politics will likely return to the fore as the presidential contest approaches. Draghi became prime minister a year ago (February 2021) and is widely given high marks. However, the best may be behind Italy, and the 10-year premium over Germany (~130 bp) is wider than when Draghi took office.
An SWG poll released last week showed that a little more half of the Italian population supports Draghi for president. With Berlusconi’s maneuvers, a snap election would seem to be the most likely outcome to find a new prime minister. The election “distraction” and the results could endanger the implementation of reforms that are necessary to secure EU Recovery Funds. Some worry that if Draghi does not become president, his political clout will be diminished.
Norway’s central bank, the Norges Bank, meets January 20. The swaps market has about 75 bp of tightening priced in this year. However, it hiked rates in December and has not moved at back-to-back meetings since 2015, which were cuts. Norges Bank has not raised rates at consecutive meetings since 2009. That said, December headline and underlying CPI (which excludes energy while adjusting for tax changes) were stronger than expected. Although the overall economy contracted in October and November, the mainland economy has been more resilient and has not contracted since Q1 21.
The Bank of Japan’s two-day meeting concludes on January 18. The BOJ will not be adjusting policy, but it will update its forecasts. Given the rise of fresh food and energy prices, the central bank may tweak its inflation forecasts a bit higher. The iteration from late last year saw prices flat for the fiscal year ending in March. Recall headline inflation was below zero from October 2020 through August 2021 and turned positive to reach 0.6% in November. The December estimate is due early on January 21 in Tokyo. There has been some talk that the BOJ could raise rates before core inflation hit the 2% target. That may indeed be the case, but not this year. The swaps market is buying it and continues to price in steady policy rates.
The BOJ had forecast that the world’s third largest economy would growth 3.4% in 2021 and slow to 2.9% this year. It seems a bit high. The OECD sees 1.8%, which we suspect is more likely. Yet, the vagaries of covid and Prime Minister Kishida’s fiscal stimulus means that Japan may be one of the few high-income countries that grows faster in 2022 than 2021. The OECD projects a 3.4% expansion this year and the IMF is at 3.2%.
The People’s Bank of China does not meet. But the softer than expected CPI, downside risks posed by the recent Covid-related lockdowns and the disruption to the property market, coupled with the yuan’s persistence have boosted speculation of easier monetary policy by the start of the Lunar New Year celebration at the end of the month.
Another cut in reserve requirements can happen at any time, and it is also possible that a token cut in the 1-year Medium-Term Lending Facility (2.95% since March 2020) can be delivered. The new week will start with Q4 GDP (~1.2% quarter-over-quarter after the lowly 0.2% print in Q3) and some details (investment in fixed assets and property, industrial production, retail sales, and surveyed unemployment). Note that last week, the World Bank shaved its forecast for China’s GDP this year to 5.1% from 5.4%. The median forecast in Bloomberg’s survey is for 5.2%.
The UK and Canada report retail sales and CPI. The UK also provides the latest reading on the labor market. Outside of some headline risk, and barring some major shock, the data is unlikely to change the trajectory of monetary policy. The market leans heavily (~85%) toward a February 3 rate hike by the Bank of England. The swaps market has four hikes fully priced in for this year.
Canada’s headline CPI looks poised to cross above the 5% threshold for the first time two decades. The full-time job growth has been simply spectacular of the last third of 2021. Around 432k full-time positions were filled. Proportionately, it would be as if the US created 4.7 mln jobs. Instead, US non-farm payrolls rose by nearly 1.48 mln in the last four months. The market expects the Bank of Canada to be more aggressive. Five hikes are fully discounted, and the market has begun pricing in a (~25%) chance of a sixth hike this year. There is a reasonable chance (~40%) that the Bank of Canada delivers the first G7 hike of the year when it meets on January 26.
Australia reports its December jobs on January 20 in Sydney. The central bank has emphasized the importance of normalization of the labor market as it leans against market speculation of a rate hike. The swaps market has about 35 bp of tightening discounted in the next six months and 60 bp in H2 22.
After losing about 360k jobs in August through October last year, as social restrictions hit, the re-opening saw all the jobs return in November (366k). Economists (Bloomberg survey median) expect a 70k increase, but the data may be too distorted to offer market participants or policymakers much insight. In the middle of last week, Australia reports more than a million cases, a dramatic surge in the country that had a zero Covid policy. Prime Minister Morrison said that 10% of the work force was on leave at any one time due to the outbreak. The transportation sector appears to be hit considerably harder (the local news claimed it was closer to 50%). The absenteeism was threatening food supplies and the government eased the quarantine rules for those transport and freight workers who came in contact with the infected.
Bannockburn Global Forex