Central banks may have to consider reducing their balance sheets faster than initially indicated in an attempt to cool increasingly hot labour markets. Investors should be wary of rising discount rates that would result from a higher yield curve.
Quantitative easing allowed central banks to artificially supress longer-term interest rates having historically been restricted to manipulating near-term rates. In doing so they were successful in stabilising asset prices which gave economic participants the chance to clean their balance sheets. While these policies have been successful in meeting these aims, it now appears they are undermining the Fed’s attempts at cooling the US economy by way of higher short-term rates.
It’s too premature to fully evaluate the impact of such policies it would appear that such policies are now undermining the Feds attempts at cooling the US economy.
It should not be taken for granted that the Fed is extremely concerned by the strength of the US labour market. With unemployment at 3.7%, the lowest level since 1969, and projected to fall to 3.0%, there are very real concerns about medium-term inflationary pressures. To date the Fed has responded by raising short-term rates while tapering their balance sheet at a pace akin to ‘watching paint dry’ – in effect reverting to the old playbook of focusing on short-term rates. As a result, the yield curve has flattened with the 10-year treasury at 3.05% compared with 3-months LIBOR at 2.70%. This flat yield curve is undermining Fed attempts at slowing the US economy as economic participants continue to enjoy historically low discount rates.
A ‘nuclear’ option?
Many view a faster pace of unwinding quantitative easing as a nuclear option. In a low-yielding environment higher discount rates would likely see a correction in asset valuations that many fear could push the US economy into recession. While this is a very real concern, any technical recession caused by corrections in asset valuations would likely be short-dated and relatively mild given the private sector remains lowly geared and enjoys large cash reserves. Talk of higher discount rates will inevitably result in another taper-tantrum but corrections are a by-product of fully functioning markets that were common occurrences before the last financial crisis.
To date the Fed has not felt pressured to flirt with this ‘nuclear option’, as short-term inflationary pressures have been minimal. This conundrum has left many commentators to proclaim the death of the Phillips Curve, the inverse relationship between unemployment and inflation that has underpinned modern monetary policy. But don’t be fooled! The Fed is very much concerned and is increasingly frustrated that attempts to normalise monetary policy are not being heeded by the market. With comprehensive data showing labour demand outstripping supply and a realisation that labour participation isn’t going to absorb it, it is only a matter of time before workers demand a scarcity premium for their labour.
Those looking for clarity from the Fed may not have to wait long with Powell speaking this Wednesday at The Economic Club of New York. The following week he will address a congressional committee. Also of interest will be this week’s G20 meeting where President Trump will be meeting with his Chinese counterpart Xi Jinping. Business leaders will be hopeful for constructive discussions that cool trading tensions and avert further protectionist measures that will only add fuel to the fire.
Brexit uncertainty continues
The Fed is not alone in facing such challenges but they are certainly the most advanced in addressing them. Should Theresa May get her Brexit deal through Parliament in December then this may very well remove the uncertainty that has suppressed economic activity in the UK to date. The Bank of England should then have the flexibility to address a tight labour market as well as growing consumer credit that could see rates rise faster than projected. Should she fail, which looks plausible, the UK will be gripped by a constitutional crisis with an unclear outcome. Those not exhausted by the ongoing Brexit debacle should look to the Bank of England’s ‘no-deal’ analysis to be released on Wednesday, followed by predictions for May’s deal on Thursday.
A mixed bag of data on the continent
The ECB is also keen to normalise monetary policy. Draghi is set to announce in December that the bank will be reigning in its asset purchasing program, which is a necessary pre-requisite to raising interest rates in 2019. Friday’s unemployment data, which is predicted to see unemployment fall to 8.0% having been 8.6% in January would support this. However, the inflation data (Friday) and economic sentiment surveys (Thursday) will be less than convincing. HICP is expected to fall, although this will largely be attributed to lower oil prices with core-inflation remaining flat. More worrying will be the economic sentiment figures which, along with November’s PMI number released last week, would suggest that Eurozone GDP is set for only a modest increase from Q3’s dismal 0.2%.
For more information, please contact Shane Canavan, Director at JCRA, at Shane.Canavan@jcrauk.com.