The pace and the degree of the ‘dovish pivot’ by the major central banks over the past few weeks has been dramatic. In addition to concerns about domestic growth and inflation, external factors, such as the slowdown in China, partly accounted for the abrupt change in global monetary policy.
But I believe the market has overreacted by pricing in US rate cuts and the Federal Reserve will have to start changing gears again over the next few months as evidence of stabilisation emerges later this year.
In the absence of a big China stimulus, guess who steps in?
As the two major headwinds from last year - a slowing China and tighter financial conditions - continue to weigh on the global economy in 2019, central banks are yet again trying to come to the rescue. Having realised another big China stimulus is not forthcoming, plans for policy normalisation have been universally suspended. Suddenly, we are back to the land of wait and see.
Of course, the Fed has been the major force driving the ‘dovish pivot’ in global monetary policy. While the overall policy direction was in line with my view, I had completely underestimated the pace and the degree of the pivot - from the now infamous ‘this cycle can last indefinitely’ in October to the need for ‘patience’ in January to ‘no more 2019 hikes’ in March, with the end of quantitative tightening by September thrown in for a good measure.
The reason? No, it’s not the domestic economy that is the main concern. In fact, the Fed’s economic outlook is ‘favourable’, with growth projected to stay above trend. Rather the external risks - such as China, Brexit and trade issues - apparently formed the drivers behind the dramatic policy pivot. Ironically, external risks at the end of last year were arguably higher - or at least not lower - than they are today. Puzzling indeed.
My take on the recent changes to the Fed’s reaction function, its policy response to economic conditions, is as follows. Firstly, it has become highly reactive to incoming economic data. Secondly, it now puts less weight on unemployment and more on inflation (we will probably find out in June the exact framework the Fed is shifting towards, but average inflation targeting seems the most likely at this point). Lastly, it is becoming more global. This final point is a tough one for the Fed to make explicitly for political reasons, but by implicitly targeting financial conditions, the Fed acknowledges the importance of global factors. Partly in the face of apparent policy restraint in China and the related drag on other economies, the Fed had to step in, abruptly suspending monetary policy normalisation.
What to expect from the Fed next
The rules of the game are clearly in flux. It’s not easy forming a high-conviction, evidence-based view on the Fed’s path from here. I still believe, however, that the market has over-reacted by pricing in rates cuts, which only come into play in conjunction with stronger evidence of a recessionary trajectory. And while weakness in the first quarter this year is undeniable, I still believe this is a soft patch within the overall adjustment to a lower growth rate more in line with its trend.
Over the past month US data has been somewhat mixed but still undoubtedly pointing to slower economic momentum. However, there are some positive signs suggesting this cycle can extend for a bit longer, even if at an unspectacular pace. Despite concerns about yield curve inversion, the probability of a recession in the next 12 months remains low.
I expect signs of stabilisation after the sharp first-quarter slowdown to emerge. In this scenario it will become increasingly difficult for the Fed to stick to its current stance. One factor to keep an eye on is whether higher wages finally start to push up prices. How much of an overshoot to the inflation target could the Fed tolerate before switching stance?
With this in mind, I believe the Fed is not done. The next hike might not be this December (it’s hard to ‘fight the Fed dot plot’ but who knows), but it could well be in early 2020. Of course, to engineer the pivot back, without causing big market tantrums, the Fed would have to start tweaking the message well before that. For those thinking the Fed will remain on the side lines until next year, 2019 should still have a few surprises in store.
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