The Fed versus the Market

Central Banks set short term interest rates and can influence longer term rates  but the market is in control of the latter and determines financial conditions in general. At times, financial conditions can move in the opposite direction to the stance of monetary policy, and we have a good example of that playing out now in the US.

The Federal Reserve has tightened policy and has signalled  this process will continue; the Fed Funds rate target is currently 1% higher than it was eighteen months ago, following four rate increases,  and the FOMC expects conditions to evolve that will ‘ warrant gradual increases‘ over time. Furthermore, the Fed’s Balance sheet will start to shrink ‘relatively soon’, as the Central Bank stops reinvesting some of the bonds purchased under QE. Yet the market is currently giving a 60% probability to rates being unchanged by year end, and broader financial conditions are now looser than they were when the Fed started to tighten.

Indeed, financial conditions in the US have rarely been easier, according to The Chicago Fed’s Financial Conditions Index. This uses over 100 financial variables (including the exchange rate, equity market volatility, credit spreads and the yield curve) to derive a weekly snapshot of risk, liquidity and leverage in the US. It is clear that the Fed is therefore at odds with the market; the former believes it is time to tighen policy, albeit gradually, while the latter acts as if the economy does not need such medicine.Moreover, some FOMC members have voiced concern that loose financial conditions carry risks for financial stability and increase the chances of a sharp correction in asset prices.

Why is the market shrugging? Unemployment is very low and  is around what many think  of as full employment, but inflation remains stubbornly below the Fed’s 2% target, and has eased in recent months. The economy is growing but at a modest pace ( 0.9% over the first half of 2017) and the market may well believe that inflation will stay low for structural reasons, contrary to the Fed view of a gradual pick up to target.

Does this  divergence matter? After all, official rates may be higher but policy  remains accommodative  ( the real Fed Funds rate is still negative) and it may well be that financial conditions may indeed move if rates do rise steadily from here, as indicated by Fed projections. If not, the Fed may have to raise rates more aggressively if it wants to secure a tightening in financial conditions overall. An inflation shock would change things but for the moment at least  markets  simply do not believe that the Central Bank needs to tighten as much as the Fed itself thinks. One of them is wrong.

Irish economy contracts sharply in Q1 but annual growth still 6.1%

According to the CSO the Irish economy, as measured by real seasonally adjusted GDP, contracted by 2.6% in the first quarter of 2017. This still left the annual increase in GDP at 6.1%, however, following substantial revisions to the quarterly pattern in 2016, with growth of 3% in q3 and a bumper 5.8% in q4. The impact on  annual growth  for 2016 was only marginal ( now 5.1% from 5.2%) but the CSO revised up nominal GDP over recent years by significant amounts; the 2016 figure is now €275bn, a full €10bn above the previous estimate and a massive €100bn above GDP in 2012.

This is the denominator used to measure the various debt and deficit ratios incorporated into the Euro zone’s  fiscal rules, and means that Ireland’s debt ratio last year is now 72.8% as opposed to over 75%, with every likelihood of a 70% reading in 2017. Yet many have argued that a better measure of domestic economic activity is required, given the extraordinary influence on the national accounts of the mulitinational sector. Personal consumption is now only 35% of GDP, for example, and is only €9bn higher than Investment spending, 32% of GDP. To that end the CSO, for the first time, have published a modified national income figure. This takes GNP ( which is lower than GDP as it adjusts  for net  cross border income outflows such as profits and interest payments) and deducts the profits of domicilled multinationals as well as adjusting for R&D spending on imports. This gave a figure of €189bn in 2016, compared with a €275bn GDP reading, and a debt ratio of 106%. However, it is clear that the economy has still being growing strongly in nominal terms on the new measure , by 9.4% last year and by 42% since 2012.

Investment spending tends to be the most volatile component of GDP and this was indeed the case in the first quarter, declining by 38% and hence accounting for  the contraction in GDP. Building and Construction rose ( by 5.8%) but this was swamped by a 22% decline in machinery and equipment investment and a 56% plunge in intangibles ( the term for spending on R&D, patents, etc). Virtually all of the latter is imported so service imports also fell sharply ( by over 10%), with total imports down by over 12%. Exports were broadly flat and government consumption barely grew ( 0.3%) leaving consumer spending as the only GDP component showing any positive momemtum, rising by 1.2%. This is still soft relative to retail sales, implying much weaker spending on services, at least as estimated by the CSO. and this divergence has been a feature over recent years.

Where does this leave this year’s annual forecast for GDP growth? The Department of Finance  expect 4.3%  but  the base effects for the second half of the year are now much more negative, albeit against an  annual figure in q1 above 6%. Our own existing forecast is less than 4% and we will produce an update in the next week or so.

Government has €200m to fund tax cuts in 2018 Budget

The Irish Government has just published the Summer Economic Statement which sets out updated economic  and fiscal forecasts, with emphasis on the 2018 Budget, scheduled for delivery in October.  Economic growth this year is still expected to be 4.3%, slowing marginally to 3.7% next year,  while the main change in the fiscal outlook over the medium term is higher capital spending, which means that Ireland continues to run a modest deficit until 2020. The new Minister for Finance also reiterated that a ‘rainy day’ fund  would be initiated in 2019, although now at €500mn per annum instead of the €1bn indicated by his predecessor.

Most interest will no doubt centre on the outlook for the upcoming Budget and the resources or Fiscal Space available to the Government to fund new spending or tax reductions. Under the existing euro fiscal rules an Expenditure benchmark is set and it now appears that Ireland will breach  the 2017 limit by some €500mn or 0.2% of GDP, so the Government now intends to undershoot the 2018 benchmark, albeit modestly.

The latter is determined by the European Commission and dictates that Ireland must limit  spending  next year to  €71.2bn from €69.6bn in 2017, a rise of 2.4% ( the benchmark excludes certain items, notably debt interest and some capital spending).  That gives a Fiscal space of €1.6bn or €2.1bn given that Ireland does not index its tax system (i.e higher prices and wages would increase tax revenue by around €500mn). Some  €800mn of that will be eaten up by demographic pressures on spending and prior commitments on pay, leaving a net figure of €1.3bn, which the Government has chosen to limit to €1.2bn.

That would translate into €1.5bn in cash terms ( because not all of any additional capital spending is included in the  Benchmark) and the Statement indicates that €1.1bn of this will take the form of additional spending ( €0.6bn current and €0.5bn capital ) leaving €400mn for tax reductions. Further, the carry over effects of last year”s cuts will use up almost €200mn of this , leaving just €200mn on budget day to fund  net tax cuts ( leaving aside any refund of water charges)

Of course it is always open for the authorities to free up additional resources by cutting  some existing spending programmes or indeed  raising indirect taxes if it wants to pay for a reduction in income tax or USC. To that end it is noteworthy that the Department of Finance has drawn attention to the cost of the cut in VAT introduced in 2011 to support the tourism and hospitality sector ( from 13.5% to 9%) . The cost of accomodation has risen by over 20% since that move, and reports suggest that the lower rate is costing the Exchequer around €0.5bn. On the available arithmetic the Government will not be able to fund any meaningful direct tax cuts unless it finds money elsewhere.

ECB caught between strong growth and weak inflation

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A  ‘reflation’ reference by Draghi was the initial  catalyst ( although later played down by the ECB)  and the pace of economic activity has  certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area  (EA) grew by 0.6% in the first quarter and  strong  survey readings  (the IFO in Germany is currently at  a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the  EA may emerge at 2.1% or 2.2% this year and hence above the 1.9%  projected in the June  ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA  but across  other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e.  a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision  in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand  ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer  limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a  gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed  also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening,  but the ECB does not have that luxury.