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“Everybody’s looking for that something. One thing that makes it all complete“

Westlife, Flying Without Wings

Last week, we discussed the recent evolution of DM central bank policy. We outlined the continuation of a common theme, or policy iteration, from the ECB the previous week to the Fed and the Bank of England last week - a more cautious narrative on the progress of inflation and, thus, the progression of monetary normalisation. On all counts, there was an announced end to the rate hiking cycle - more formal and explicit in the case of the ECB and Fed but more convoluted and implicit from the Bank of England (through both the continued dissents in favour of rate hikes, and, the narrative that inflation projections, and thus policy bias, are likely bookmarked between forecasts conditioned upon market rate pricing and those conditioned on a constant rate assumption - effectively inferring the need for rate cuts through the forecast horizon to prevent inflation falling significantly below target, or a policy path somewhere between what the market is currently pricing (several rate cuts in 2024) and unchanged).

Perhaps the defining sentence in the Fed statement was, “The committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards target” (my emphasis). Strikingly similar wording was also dominant at the ECB and Bank of England meetings. None suggest that they are looking for a further deceleration in growth or inflation to warrant rate cuts, nor that they are unhappy with the decline in inflation (Powell was clear that the Fed are looking for “more good data, not better data”) that has (so far) not been a function of, or significantly detrimental to, growth. It seems, to quote Westlife, “everybody’s looking for that something. One thing that makes it all complete” … at least from the perspective of attaining their respective monetary policy mandate goals.

Since the meetings, markets have jostled with the timings of DM rate cuts and even focussed on the order in which they may occur (this is of very limited value from our perspective - especially as the ‘who cuts first’ race is just as likely to be a function of the different policy meeting dates as much as the urgency (or otherwise) of monetary easing). And, perhaps more significantly, DM rate path expectations have been driven by the data releases - unsurprising for central banks that have, above all, emphasised the data (not date) dependence of their respective monetary policies.

At the current juncture, the wider macroeconomic and monetary policy debate has centred around a few key debates: (i) is the current data giving a true gauge of the underlying strength of the economy (particularly in the US) and, (ii) if the growth outperformance relative to expectations is correct and persistent, is it a function of blockages in US monetary transmission or is the equilibrium rate of interest, or r*, higher (either temporarily or permanently). While this piece is not intended to provide detailed answers to these complex econometric questions, we have some thoughts.

As far as the data is concerned, we are unconvinced that such a significant tightening of financial conditions could leave little or no impact on domestic demand and or business investment. However, in the near term, we are still biased towards a soft landing for growth (and a hard landing for inflation). Indeed, it is certainly possible that there is distortion in the seasonal adjustments that has meant the January payroll data gives a misleadingly strong snapshot of the labour market (one not mirrored by other indicators). Similarly, the bad weather in some parts of the US likely distorted the wage inflation data higher, again a bounce that was not supported by other (more rigorous) wage indices.

There have been a number of detailed research notes of late that have shown small or even negative drag on US Corporate Net Interest Margins (as debt was refinanced at low levels and current cash holdings command a significantly higher return than the debt financing costs - implying perversely that cutting rates could tighten conditions for corporates?). Similarly, due to the different interest rate liability structure on US mortgages, low rate mortgage loans and significant pandemic fiscal transfers likely leaves the consumer significantly better off than headline rate levels would historically suggest. Indicative of a weaker than normal policy transmission.

However, while the huge fiscal expansion in the US is an important consideration, there are also signs of emerging fragility. Headlines over recent days have highlighted the problems in relation to the Commercial Real Estate (CRE) market in the US (specifically office buildings and low post pandemic occupancy / valuations) - not just in relation to the regional US banks (NYCB) but also in relation to notable exposures across Europe and Japan. This week’s Fed Senior Loan Officers Opinion Survey (SLOOS), also highlighted a larger tightening of conditions in consumer credit (notably autos and credit cards). Indeed, there are increasing signs that the cushion of excess savings has been fully depleted as delinquency rates in these two sectors begin to rise rapidly above pre-covid levels.

Lastly, on the debate over a higher r*, we are doubtful that this is the case. We are more inclined to see recent economic outperformance as a function of the combination of weak (or more likely delayed) monetary transmission from the high policy rate rather than a sustained higher equilibrium - the huge fiscal stimulus clearly plays a significant role. As a proxy to equilibrium rates there is little evidence that there has been any rise in equilibrium growth (indeed they have likely fallen across Europe), nor, inflation (long run inflation expectations have remained remarkably stable) nor, despite the promise of AI, productivity growth.

So, while the vast majorities of the most recent DM central bank communications were dovish, the reaction function to continued disinflation remains one of caution. It is likely that they view the cost of failing to bring inflation down as higher than the cost of bringing inflation a little below target (as the worst outcome would be unanchored inflation expectations). Thus, current uncertainties, anomalies, or extended distortions in the data likely induce a hawkish (less dovish) bias- a hesitation bias - even with “the Policy rate is well into restrictive territory” [Powell] and as we pointed out last week, the passive tightening risk (that falling inflation continues to push real rates higher with nominal rates unchanged) remains.

Many readers will be familiar with the Wile E Coyote cartoons where he runs off a cliff but only plummets once he looks down. In some respects this is likely a possible scenario for the US economy - albeit at this stage not a cliff edge but a gradual incline. On that basis it could be argued that inflation is flying without wings… and growth may be running without ground!

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