“I fought the law and the law won”
The Clash, I Fought The Law
English philosopher, jurist and social reformer, Jeremy Bentham once famously said that “the power of the lawyer is the uncertainty of the law”. Given the acute uncertainties that dominate the global economy, perhaps we are lucky in the fact that those in charge of the global monetary response - not just Powell and Lagarde, but also notably Kuroda - are foremost lawyers by training. There have certainly been periods over recent years and unprecedented events where markets have taken different views and interpretations, but it is likely that the uncertainty of the Macroeconomic backdrop has boosted the power of these lawyers.
Last week, we discussed the milestone monetary policy evolution of the ECB, as benchmark rates were lifted 50bps - their first hike in more than a decade, and the subsequent and immediate shift to a more data dependent monetary policy in the face of a potentially acute energy security crisis and a political hiccup in Italy that threatens to delay the fiscal response. Arguably, the ECB also invoked the power of the lawyer in creating the new Transmission Protection Mechanism (TPI), built, one could argue, on an impressive amalgamation of constructive ambiguity.
“In short, [last week’s] ECB meeting will likely be retrospectively viewed as an important meeting from a historic perspective, not only due to the fact that the EC drew a line under its negative interest rate policy (NIRP) after more than a decade; nor due to the fact that the GC announced unanimous support for its most interventionist but also most convoluted and ambiguous policy to date; nor due to the fact that it likely signalled a notable concern over the impact of the EUR weakness on consumer inflation; BUT also that it came alongside the reopening of the Nord Stream 1 gas pipeline. From my perspective, the gas flow from Russia is the most significant factor for European economic fundamentals for the remainder of the year.”
- Is it the end of the NIRP as we know it?
This week, it was the turn of Chair Powell and the Fed.
While there had been some speculation following the June CPI data that the Fed could (again) speed up the pace of US rate hikes, expectations for a 100bp hike in July were relatively short lived, following a quick response from FOMC members downplaying the likelihood. Indeed, going into the meeting, expectations had been steady at around 75-78bps. On this basis, it is perhaps not surprising that the financial market reaction to the hike was extremely muted.
Just as the ECB had done last week, however, the Fed removed the forward guidance component of the policy communication. This makes a lot of sense in both instances. For the ECB, the level of uncertainty following the ‘easy’ hike (removing negative rates but remaining below neutral) remains very high due to the respective opposing risks to monetary policy of energy security, and thus recession risk (or demand destruction) on the one hand, and rising inflation on the other. For the Fed, the 75bp hike this week takes them to their best estimate of the current neutral rate, and thus from this level, the implications of further tightening are greater for the demand side – thus, a more balanced consideration for forward looking policy decisions.
From our perspective, this general point - that the Fed narrative became more balanced after attaining their objective of “expeditiously raising rates to more normal (or neutral) levels” - is the most defining point of the July FOMC, and will represent a watershed as such.
There are some specific areas that are worth highlighting that both emphasise and contextualise the Fed’s more balanced approach to rate hikes, going forward. Firstly, and most obviously, was the change in the statement growth narrative - from “activity appears to have picked up after edging down in the first quarter”, to “recent indicators of spending and production have softened” - despite this, Powell pushed back on the prospect that the US was currently in recession, citing very strong labour market, wage growth and private sector balance sheets. Also noteworthy was the suggestion that markets should take the Q2 GDP flash estimate with a “grain of salt”, preferring the scenario of a rebalancing of supply and demand through a period of below potential (but notably not negative) growth. For now, we are more inclined to view this week’s negative Q2 GDP as preliminary (transient?) and still have a glass half full view of the US economy and significantly the US consumer - as some of this week’s earnings data would clearly attest.
The other significant signal from Powell came from his reference to the fact that there are still effects of previous tightening decisions to be felt in the economy. This cycle has been very unusual for a number of reasons, but an old rule of thumb was 13 months between a rate move and its full effect being felt on the economy. This is more important for the Fed to gauge, as policy moves into restrictive territory. It is clear that it is the intention of the Fed to move into restrictive territory; indeed, Powell made several references to the June SEP’s (which he referred to as their best estimate of current growth and policy trajectory), indicating 3.25-3.50% Fed Funds by the end of the year and a further 50bps of tightening in 2023.
This is where things get interesting, from my perspective. The Fed is forecasting a policy rate that continues to rise through 2022, and rises a further 50bps in 2023, albeit at a pace that slows from the “unusually large” current 75bp pace. However, the market is pricing a Fed Funds curve that is raised to a peak of around 3.30% and is then cut 50bps in 2023. What is interesting here is the perspective, the signalling, the risk premium. The Fed’s primary concern is maintaining control of the inflation narrative. In attaining that goal, it is important that the Fed talk tough on inflation. In this instance, they achieve this through an ‘inflation risk premium’ (+50bps?). The Market, on the other hand, have been convinced by the primacy of the inflation mandate of the Fed, and are thus more concerned about the resultant demand destruction. Thus, the market is pricing a ‘growth risk premium’ (-50bps). I guess that means that a soft landing leaves the front end relatively flat somewhere in the middle, in “moderately restrictive” territory.
We think demand is moderating, but we are not sure how much.
This more data driven approach also has the potential to reduce overall volatility (especially into the Summer) but increase the day weight volatility components for the relevant data prints. Interestingly, the gap between this week’s Fed meeting and the September meeting is unusually long and thus contains two CPI prints and two payroll prints - by which point markets should have a better comprehension of the evolution (and interaction) of inflation and growth and thus smoothing the volatility along the way.
The dichotomy between the Fed Dots and the market pricing is stark, and as we said, likely reflects the very different perspectives of the market and policymakers. The Fed maintains that there is a path to a soft landing (we have argued before that a drop from a stimulus-induced transient economic boom back down to equilibrium growth is not a recession even with a little volatility). AND as The Clash found out to their chagrin, it doesn’t always pay to fight the law!
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ECB Meeting Minutes, 21st July 2022 - https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp220721~53e5bdd317.en.html
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