Thursday, February 21st, 2019
In our new world of “fake news”, there are increasing observations of fake excuses, fake conclusions and fake reasons. In this environment, we suggest that January’s pronouncement of monetary policy changes by the US Federal Reserve (the Fed) through its Chairman (Jerome Powell) be scrutinised to determine whether Powell was being totally honest.
In its January policy update, the Fed adjusted its forward guidance on monetary policy. It effectively reversed its December outlook guidance, which had indicated that there could be up to 4 interest rate increases (1% in total) for 2019.
Under questioning from journalists, Powell stated that interest rate increases would be slowed, maybe curtailed and, depending on circumstances, may even be reversed. The reduction of the Fed’s balance sheet (by selling down bonds and other assets) would also be slowed. The Fed would keep all options open in its balance sheet management. Therefore, by implication, the reintroduction of quantitative easing (QE) was a possibility.
With these statements, Powell seemingly created a “Back to the Future” moment for markets – or was it a rerun of “Groundhog Day”?
Federal Reserve Chairman Jerome Powell … time to change course.
The equity markets, and indeed most risk-based asset markets, loved the possible return to unlimited central bank support. The Fed would again support risk markets under the guise of defending the US economy against a growing list of global uncertainties.
The central bank PUT was back in play because the Fed suggested it was prepared to adjust monetary policy whenever it was needed. The supportive monetary policies that were created in 2009 and which had endured to mid-2016 were to be brought back.
Powell’s statement makes for interesting reading as he attempted to justify a change in policy despite strong economic indicators – at least in the US.
“The U.S. economy is in a good place, and we will continue to use our monetary policy tools to help keep it there. The jobs picture continues to be strong, with the unemployment rate near historic lows and with stronger wage gains. Inflation remains near our 2 percent goal. We continue to expect that the American economy will grow at a solid pace in 2019, although likely slower than the very strong pace of 2018. We believe that our current policy stance is appropriate at this time.
Despite this positive outlook, over the past few months we have seen some cross-currents and conflicting signals about the outlook. Growth has slowed in some major foreign economies, particularly China and Europe. There is elevated uncertainty around several unresolved government policy issues, including Brexit, ongoing trade negotiations, and the effects from the partial government shutdown in the United States. Financial conditions tightened considerably late in 2018, and remain less supportive of growth than they were earlier in 2018. And, while most of the incoming domestic economic data have been solid, some surveys of business and consumer sentiment have moved lower, giving reason for caution.”
Then to add some clarity to the uncertain but positive outlook –
“This change was not driven by a major shift in the baseline outlook for the economy. Like many forecasters, we still see “sustained expansion of economic activity, strong labor market conditions, and inflation near … 2 per cent” as the likeliest case. But the cross-currents I mentioned suggest the risk of a less-favorable outlook.”
Are the reasons stated for adjusting monetary policy the real reasons?
We don’t believe so and doubt whether they fully disclose the Fed’s real reasons.
For many months, we have questioned the logic of the Fed pursuing a monetary tightening regime (through lifting interest rates) and introducing quantitative tightening (reducing the Fed’s balance sheet), particularly as both Europe and Japan continued to do nothing. The Fed was going alone when the world requires that all major central banks coordinate their policies to normalise interest rates.
There is growing evidence that the world needs to extract itself from unrelenting and distorting monetary support. It is our view that negative real interest rates and QE policies have the potential to create a rolling cycle of low growth and mild downturns. We believe the developed world under current monetary settings is heading towards a “Japanese syndrome” – the low growth, low inflation that has inflicted that economy for the last 25 years.
Our first table shows the predicament that the Fed had created as it lifted interest rate settings in the US.
The seven interest rate adjustments by the Fed since early 2016 have not been supported by either the European or Japanese Central Banks. The interest rate differential between the major developed economies has lifted to historic highs. The flow of speculative capital into US dollars has been a natural consequence.
However, it is the next few charts that give us a deeper insight into the more significant issues that the Fed must surely be concerned about. It lifts the lid on the real reason why the Fed had to stop lifting interest rates in the US.
The first shows the forecast jump in interest payments by the US government to meet its burgeoning debt levels caused by a blowout in the FY19 budget deficit. The US budget office is forecasting that, based on current bond yields, the US government interest bill will rise from 1.25% of GDP to 3% of GDP by 2025.
An interest bill of 3% of GDP would consume about 12% of budget revenue (ie tax collections and government charges), up from 8% today. Such a scenario would make the US budget increasingly difficult to fund through the bond market and require the support of an enduring QE program.
Today the US budget is comparable to the near-disastrous position in Italy, which has an annual 8.3% drawdown on budget revenues to meet its interest obligations.
In passing, it is noteworthy to compare Italy with Japan. Japan has government debt of 240% of GDP (Italy 130% and US 100%), but pays less interest as a percentage of government revenues. Today, the Bank of Japan’s balance sheet equals 100% of the country’s GDP and the BoJ owns 50% of all government debt on issue.
This suggests that QE must return as a monetary mechanism to help fund the US deficit, keep bond yields low and hold down the US government’s interest bill. Further, the Fed must hold cash rates below the long-term bond yield. The creation of a negative yield curve (where cash rates exceed long term bond yields) would put immense pressure on the US financial system and push the US into recession.
While Powell is correct to identify the slowing economic growth in Europe and China, they are a relatively small part of the problem that presents for US monetary policy. The real issue is that the US government is ultimately heading for a debt crisis and that is an issue that the Fed and President Trump do not want to present to the US public.
US economy performing well – looking backwards
The US economy continues to grow steadily, but it is important to understand that it has been significantly stimulated by the massive Trump fiscal deficit (5% of GDP), which may be thought of as “a sugar hit”.
Our next chart shows that it has been a long recovery for the US since the GFC, with only the mild recession in FY16 that checked the growth cycle.
The current level of US growth is where the economy historically peaks before a downturn. However, the chart above has never captured a cycle (pre-2008) where QE has been utilised.
While the economic cycle looks mature, the US economy is still producing record numbers of new jobs. The US economy is transitioning further into services and an ageing population is ensuring plenty of job openings are created by retirees. For the first time in twenty years, the US economy is producing more jobs than there are registered unemployed people.
Growth in employment has now fed through to wages which are growing solidly. However, wages growth has not yet reached the level where historically the Fed has moved to tighten rates. This suggests that the decision by the Fed to raise interest rates in 2016 was designed to normalise rates rather than a response to excessive growth in wages or the risk of inflation. It is now clear that they focused on that issue because they had no idea that the incoming President would blow the budget!
Mild wages growth, depressed oil prices and the deflationary benefits of trade with China (cheaper imports) have ensured that inflation has remained below the peaks recorded over the last 20 years.
Core inflation of about 2% does not require the Fed to adjust interest rates further. US cash rates currently exceed the level of inflation – in stark contrast to Europe and Japan.
The US trade position is both a cause and a consequence of its sustained economic growth. The chart below shows that the “goods” deficit of the US has lifted towards US$900 billion and while it is at a record level in dollar terms, it is not as a percentage of GDP and the latter is a far more important measure.
When the trade in services (US$300 billion surplus) is added to trade in goods, the total trade deficit is approximately US$600 billion p.a.
Inside these figures are some important recent developments. First, the services surplus has a component of growing Chinese demand for education and inbound tourism. Second, the US is rapidly emerging as an exporter of energy, and if it focused more on this opportunity then the trade account would improve.
The bulk of the US trade deficit resides with China, which currently sits at about US$350 billion p.a. In the second half of 2018, as the trade dispute escalated, there was a noticeable decline in trade between the two countries, but the deficit increased because US exports to China fell faster than Chinese exports to the US.
The Fed noted the slowing of growth in China as an issue of concern. However, we know that this slowdown has been affected by the trade dislocation caused by the current failure to reach an agreement.
In the meantime, the Chinese administration has held its underlying fiscal deficit at a high level (circa 4% of GDP) while allocating another 5% of GDP to economic development and infrastructure projects.
The combined fiscal deficits of the US and China will ensure that the world will not have a recession in 2019. Thus, the Fed has thrown in a furphy by claiming economic headwinds as the reason to slow interest rate rises. The real reason is the increasingly difficult funding position of the US government. Fake news!