Powell Is a Welcome Surprise
However, the first press conference by Jerome Powell as chairman of the Fed was a positive surprise.
Powell was clearly cautious with long-term estimates, an Achilles’ heel of a Fed that consistently missed its own inflation and growth expectations. His response to a reporter on his predictions for 2020 was perfect: The Fed has to monitor the changes that are taking place right now and avoid giving optimistic estimates that only make them lose credibility.
And now, credibility is key, as the Fed doesn’t have much of it left.
Powell was technical, correctly agnostic to stock market reactions, and exceptionally aware of the risks in a market extremely oriented toward external stimuli.
For market operators, having a new Fed chair with such an unpolitical and market-agnostic profile may not seem like good news. But it is. Too many investors play the “bad news is good news” game. That is, to expect poor macro data so that monetary stimulus is perpetuated.
This carry trade leads market participants to bet on cyclical assets and inflationary themes while expecting economic stagnation and more expansionary policies. This is dangerous.
What Powell explained is very important, and the path of rate increases is clear. The “buy anything” party is over. And this is good.
The U.S. economy can absorb a rate hike path up to 2.75 to 3 percent in 2019 without a problem. In fact, if the economy could not absorb it, we would have to be very concerned about the kind of growth and investments we have.
With the Fed policy pretty clear for the near future, the key questions are now the following:
- What do we do with the $7.5 trillion of negative yielding bonds globally?
- Who will accept historic-low bond yields in emerging markets and in old Europe? Greece and Portugal have a lower short-term yield than the United States.
- Who believes that all European countries can finance themselves at lower rates than the United States, discounting inflation?
- Who buys high-yield bonds with less than 300 points over Treasurys?
The answer is no one. Real market demand for these extremely expensive assets simply vanishes. The mirage of “high liquidity” disappears in front of any seller’s ask order.
No Problem for the US
I do not worry about the United States. The transmission mechanisms are very flexible and powerful. Less than 20 percent of the real economy is financed through banking, compared to 80 percent in Europe.
In the United States, the entire financial sector makes mark-to-market valuations of assets. In Europe and other large economies, the sector uses “mark to value.” What does that mean? Excel spreadsheet estimates instead of real prices.
Then we will see the risk of the domino effect. Real demand evaporates for expensive “low-risk assets” (bonds), then equities fall, illiquid assets’ valuations are tested, transactions fall, and banks’ core capital erodes.
Emerging market and European economies that grew accustomed to cheap and abundant U.S. dollar inflows then see the reverse. Fund flows go back to the United States regardless of investment bankers’ comments about value, growth, or inflation. It is called “the sudden stop.” And it is essential to stop a bubble from being a systemic risk, which may be too late anyway.
No Inflation Risk
In the United States, market participants are worrying about inflation, but the Fed’s expectation of inflation is also very moderate. It expects a core consumer price inflation of 2.1 percent in 2019 and 2020 and that is well below what inflationists fear. The disinflationary trends of technology, debt, and overcapacity are much more important than inflationary fiscal policy.
The path of rate hikes is absolutely essential to reducing the enormous risk of bubbles creating a systemic risk. In fact, the current rate hike regime may be too little, too late, and some commentators still say the Fed’s policy is hawkish.
Raising rates to 1.75 percent in an economy growing at 2.5 percent and almost in full employment while maintaining a nearly unchanged Fed balance sheet of $4.4 trillion is not a restrictive policy. It remains extremely expansive.
Powell knows one thing: If the Fed does not accumulate tools now, while the economy is expanding, it will not have any weapon when the next recession hits. If imbalances are perpetuated, it will not only be a case of finding itself without tools; by then, monetary policy will not solve anything. Or do we think that lowering rates from 1.75 percent to zero again and increasing the balance sheet further will solve the next crisis? No, it will not.
A more technical message from a Federal Reserve chair who feels less “trapped” by market volatility should be welcomed by the markets. So should a more prudent policy. Is it ideal? Maybe not. But it is much needed and a welcome surprise.
Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.