“I know but I don’t know”
Blondie, I Know But I Don’t Know
Last week, we discussed the prospects for monetary policy iterations and the inference for the currency space from this week's Federal Open Market Committee (FOMC) and BoE meetings (we will leave the RBA out of the discussion for today, suffice to say that they put all of the concerns over beginning a rate hike cycle before key wage data and in the run up to a general election aside and offered a very hawkish take). If we were to summarise the narrative of the Federal Reserve System (Fed), the BoE and the resultant 24 hours equity market sentiment then ‘The Good, The Bad and The Ugly’ comes close to summing it up!
We set the scene last week: “Prior to the blackout, the Powell (and wider FOMC participant) message was very clear - the Fed intends to move in an expedited manner (50bps at least for the first couple of meetings) towards neutral (2.25-2.50%?). The Press conference will be closely watched, but as has been Powell’s style in recent months - preparing the markets ahead of time and then delivering just that (no more, no less), it seems likely next week follows the same path.”
The reality followed a very similar path. The Chair of the Federal Reserve started by saying that the Fed are going to move ‘expeditiously’ to more normal levels (choosing to avoid using the language defining a path ‘towards’, or even ‘to’ a neutral rate - and the resulting uncertainty or speculation of what exactly constitutes neutral). Furthermore, later in the discussion he described neutral as a ‘concept’ that is estimated by the committee to be somewhere between 2 and 3% - It is indeed a moot point as to whether the concept of a neutral rate can apply to a nominal rate at all - making the nominal estimates even more conceptual. BUT what the Fed Chair likely aims to achieve in this regard is a more destabilising focus of markets on the implied policy tightening (i.e. rates above neutral), and the negative growth connotations that this implies, when it is not clear at this stage how high rates will need to go - let alone how far beyond an estimate of concept of neutral rates.
On the economy however, the Chair of the Federal Reserve and the Fed were much more positive, stating that the economy is “very strong and well positioned to handle tighter policy”. Further, he emphasised that household and business balance sheets are in very strong shape, the labour market is very, very strong and the economy is well positioned to handle stronger monetary policy - a narrative that fits more closely with our glass (more than) half full view of the US economy.
Furthermore, on the Labour market, the Chair of the Fed was also more positive. Many commentators had been discussing the need for the Fed to drive up the U/E rate in order to calm inflation. The Chair of the Fed took a different line, stating that “there is a path to moderate demand without unemployment having to go up, that the Fed can put demand and supply into a better balance and that “there is a good chance of a soft landing” (likely through additional participation, slowing job creation and less supportive fiscal and monetary policy).
Lastly, on Ukraine and China, he emphasised that Fed policy tools do not work on supply shocks, but there is a job to do on demand. This is interesting in that it is suggestive of a Fed framework that separates the monetary focus on headline inflation between demand and supply components (perhaps 3% demand inflation and 5% supply-driven - in which monetary policy cannot influence the latter) – a concept we have noted over recent months.
The Bank of England had a very different emphasis. Whereas the overriding focus of the Fed is clearly to achieve an expeditious policy normalisation towards more normal levels, the BoE started this week already at pre-Covid levels of interest rates, and a more pronounced cost of living crisis driven predominantly by the UK’s terms of trade shock.
Indeed, the striking headline from the Bank of England’s May Monetary Policy Report was the headline inflation forecast for Q4 (and full year) at an eye watering (and importantly activity sapping) 10.25%! Furthermore, while the Fed expect “some signs” that inflation is peaking (next week’s CPI reading will give a preliminary test of this hypothesis), the BoE explained that the UK will have a delayed peak in inflation due to the fact that the government energy price cap will delay the next discrete energy price shock.
Furthermore, the more acute concerns about the implications from growth of the shock to real incomes (biggest annual shock in BoE history, bar one) lead to a more hesitant path of policy tightening from the Bank.
However, as markets struggle to quantify the implications of inflation tail risks by pricing inflation risk premia in the bond market (increasingly, it seems on the prospective use of QT to tighten financial conditions) risk sentiment has been sharply undermined and thus risk assets have sharply underperformed.
We retain a glass half full view of the global economy in the medium term. However, in the near term, the inflation dynamic likely drives weaker risk sentiment - further fuelled by the desire of the EU to attempt to replace energy supply lines when it is not clear there is the capacity to do so (increasing growth and inflation risks). The global macro picture thus becomes more volatile. Indeed, Richard Feynman famously once stated that “if you can’t explain things in simple terms then you probably don’t understand it”. Suffice to say the near-term macro backdrop (and all the broad commentator narrative seeking to explain them) is becoming increasingly complicated!
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Bank of England - https://www.bankofengland.co.uk/monetary-policy-report/2022/may-2022
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