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.

European Commission latest to convert to Fiscal Expansionism

The widely accepted view on the Great Depression is that it was exacerbated by a series of policy errors- trade protectionism, tight monetary policy and contractionary fiscal policy. Consequently, given the lessons learned,  the Great Recession in 2008-9 prompted a substantial policy reaction across the globe, with a massive easing in monetary policy accompanied by counter cyclical fiscal policy. Oddly, though, policy makers then decided that debt reduction should take priority, and fiscal policy generally became contractionary even when the global recovery began to falter and lose momentum, with monetary policy seen as ‘the only game in town’. That emphasis on the  perceived dangers of high and rising  sovereign debt resulted in new and stricter fiscal rules in the Euro Area (EA), emphasising the need for a steady and persistent reduction in budget deficits.

Policy doubts eventually began to emerge, including from the IMF, with evidence questioning whether ‘austerity’ actually reduced debt levels and claiming that the  negative multiplier effects of contractionary fiscal policy were steeper than previously believed. Doubts also grew about the effectiveness (and  possible adverse consequences ) of loose monetary policy particularly after the adoption of negative interest rates and large scale QE. The ECB has also changed its tone of late, accepting the need for monetary policy to be complemented by some expansionary fiscal policy in the EA, albeit while still respecting the existing fiscal rules.

Academic debates  on fiscal policy have also intensified, with the case being made that budgetary policy can be more effective at or around the zero rate lower bound, but  events have transpired to take fiscal policy centre stage in the real world. The UK government has already announced , post the Brexit vote, that it has abandoned its previous pledge to balance the budget by 2020, and is expected to announce a more expansionary fiscal path later this month. In the US,  markets now expect fiscal policy to be far more expansionary under the incoming Trump Administration, although it remains to be seen how much of the campaign rhetoric will translate into policy action.

Closer to home, the European Commission has just announced , for the first time, a recommendation on the overall fiscal stance in the EA, and is advocating that it should be expansionary in the coming year, amounting to 0.5% of GDP , equivalent to a €50bn budgetary injection. On existing  national plans , the  overall  EA fiscal stance is expected to be neutral in 2017, after being modestly expansionary in 2016, and the Commission believe that a number of countries have the fiscal space available to raise spending and/or cut taxation, although it cannot force any action. The group comprises Germany, Estonia. Malta, Latvia, Luxembourg and the Netherlands. In practice, the Federal Republic is the only member with the size to affect the EA as a whole, and while calls for Germany to adopt a more expansionist policy in the interests of the wider zone have been made before, it is novel and perhaps surprising to see Brussels join in that chorus.

Fed Hard to Fathom

In December last year the US Federal Reserve tightened monetary policy, albeit by only a quarter point, citing the ‘considerable improvement in labour market conditions’ and an expectation that inflation would gradually recover to the desired 2% level. The accompanying statement emphasised that further rate increases would be gradual, although the projections released at the time from the 17 FOMC participants (the ‘dot plot’) indicated a median expectation  that 2016 would see four further quarter point rises.

The market was not convinced but the latest ‘dot plot’ , released in mid-March, was still a surprise to many, as the median expectation now showed only two rate increase by year-end. True, growth was now projected to be marginally weaker in 2016 and 2017 but the unemployment rate was also forecast to be  lower, falling to 4.5%, against  4.8% in the long run. Inflation ( the Fed’s measure is the personal consumption deflator)  was expected to end the year at 1.2%, down from the previous 1.6% forecast, but the core rate forecast  (defined as ex food and energy) was unchanged at 1.6%.

Monetary policy is deemed to have ‘long and variable lags’ so one might think that unemployment around the Fed’s desired level alongside an expectation that inflation will pick up would be consistent with steady rate increases. let alone a change to a more dovish rate outlook. Core inflation has actually  picked up of late , rising at an annual 2% rate over the past three months, and the annual rate is 1.7%, which is above the Fed’s expectation for the year-end. Yet Janet Yellen, in a recent speech, emphasised that low inflation expectations were now a concern. Survey measures had shown a fall while market based measures had also declined ; the 10-year break-even inflation rate fell to 1.2% in February. She highlighted the risk that lower expectations would feed into wage and price setting, so increasing the probability of inflation remaining below target for longer. The Fed Chair also flagged the possibility that  the unemployment rate could fall much further without triggering wage inflation and  also pointed to international risks to the US economy.

So it is now very difficult to see what would trigger a rate rise in the coming months. A further improvement in the labour market does not seem a sufficient condition and higher spot inflation may not be sufficient either, given the emphasis put on inflation expectations. In fact the latter is heavily influenced by spot inflation anyway, particularly high frequency purchases like fuel, and  market expectations have actually risen again of late, perhaps driven by the rebound in oil prices in March.  Crude prices have  fallen back again in the past week, however, and this may dampen expectations again.

The Fed funds future for December is trading at 0.5%, so the market is no longer convinced we will see any rate increase this year. Central banks generally tread a line between Discretion on policy or following a more Rules based approach and the former is driving the Fed at the moment, which makes for flexibility but makes it very hard to read their next move.

 

The Price of Oil

It is not that long ago that the price of crude oil approached $150  a barrel (a barrel of oil equates to around 35 imperial gallons) and  the airwaves  were full of discussions on  ‘peak oil’ and the possibility of $200 as a realistic price forecast. In the event prices collapsed in the wake of the financial crisis , declining to around €35, before recovering and stabilising at over $100 from 2011 to mid 2014. Prices then fell precipitously, to around $50, before rallying briefly in the early months of 2015  but then the slide resumed, with the downward momentum increasing in recent months, taking Brent crude,the European benchmark, below $30 for the first time in over a decade.

The demand for oil is very unresponsive to price changes in the short term (in economic terms the price elasticity is close to zero) so any change in supply will have a large impact on price, be it on the upside or the downside, but it is useful to distinguish some medium term factors affecting the market from some shorter term developments.

The demand for oil will rise with economic activity and so it is not surprising that global demand in 2015 , averaging 94.5 million barrels a day (mbd ) according to the IEA, is considerably higher than it was before the crash in 2007 (86.5mbd). What is surprising though is that demand in the developed world (OECD countries) is actually 3mbd lower now than it was  eight years ago, leaving emerging markets as the driver of the increase in world demand for crude, with China being particularly important (it now accounts for 12% of global oil demand from 8% in 2007).

There have also been some fundamental changes on the supply side of the market. Non-OPEC supply has risen by 7.5mbd since 2007, from 50.9mbd to 58.4mbd, driven by a surge in production from North America, where output has risen to 19,8mbd from 14.3mbd. Consequently , the implied call on OPEC supply has not greatly changed and the cartel’s market share has fallen. In the past Saudi Arabia has acted as ‘swing’ producer in OPEC, cutting output in order to stabiise prices at times of excess supply, but it changed policy in 2014, seeking to maintain market share, Iraq’s output has also risen substantially ,  and the resultant increase in OPEC output has contributed to persistent excess supply in the market; supply exceeded demand by  1mbd in 2014 and by a further 1.8mbd in 2015. Stocks have therefore risen sharply and the scale of the overhang has clearly put huge downward pressure on crude prices.

In terms of shorter term factors, global growth has consistently disappointed (the IMF has again reduced its  forecast for 2016) and China is slowing, so the market has scaled back estimates of oil demand growth for this year (the IEA expects 1.2mbd). Non-OPEC supply may actually fall a little but this is likely to be more than offset by higher Iranian output (now that sanctions have been lifted)and from other OPEC members, so the consensus is that excess supply will grow in 2016, albeit at a slower pace than of late. In addition, global demand fell unexpectedly in the final quarter of 2015, back to 95mbd from 95.5mbd, as a result of an  unusually mild early winter  in the Northern Hemisphere, but supply was broadly unchanged at 97mbd, exacerbating the excess supply issue.

The plunge in oil prices obviously benefits oil importers and  hurts oil producers so the global impact is difficult to disentangle. The IMF believes that the boost to real consumer incomes (via lower retail fuel prices) and the  reduction in  energy costs for firms offsets the  loss of spending power from oil producers and investment in oil production,; global growth may be boosted by over 1% as a result of the recent price falls, according to the Fund. Others disagree, arguing that the cut in investment spending in the US on oil production, for example, is offsetting the impact of lower fuel prices for consumers. The positive correlation between equity markets and the oil price of late implies investors believe the latter or see the price decline as demand driven rather than from the supply side, That does not fit the facts, however, and although it is anyone’s guess how low prices will go in the short term one doubts if the marginal cost of oil production is $30 or below so prices at that level or lower are not sustainable.

We are all Sectoral Stagnationists now

The  decision by the  US Federal Reserve to leave monetary policy unchanged at the recent FOMC meeting was interesting on a number of fronts, including the emphasis given to the global situation in informing  the outcome. OF more significance was the economic forecasts supplied by the 17 Fed members in confirming a trend evident for some time- the US Central Bank, like other policy makers  across the world, has become increasingly gloomy about the medium term outlook for growth, and as a corollary expects interest rates to remain much lower than generally seen in the post-war era. That view has been around markets and academia  for a while but it now seems to have permeated official thinking in a serious way.

Secular Stagnation is the thesis that growth in the medium term  will be weaker than we have become accustomed to, certainly in the developed world and possibly also in many parts of the developing world. Labour force growth has slowed in the West and in some cases is already falling, which reduces potential GDP growth, but a feature of the stagnation view is an emphasis on the savings/ investment balance. Ben Bernanke was one of the more prominent economists drawing attention to global excess savings, which he saw as putting downward pressure on interest rates  and sought to link this to the observed trend decline in longer term bond yields in the US, the closest approximation to a global risk free rate of interest. More recently, others have drawn attention to  investment spending, which is weak by historical standards,  which is put down to a number of factors, including  changing technology ( the capital spending generated by the internet versus railways or electricity for example) or simply a  perceived decline by companies  in profitable investment opportunities. Capital spending by governments, once the mainstay of Keynesian expansionary fiscal policy, has also fallen foul of the new orthodoxy ,  which extolls retrenchment.

The result of this combination of higher savings and lower investment demand is a decline in the equilibrium real rate of interest. Indeed, some argue, like Larry Summers, that the equilibrium  real rate may now be negative. With nominal rates now at the zero bound the only way to get negative real rates is to generate some inflation but so far policy makers have not succeeded in that aim, with inflation closer to zero than to official targets in many economies. Indeed, with deflation in some cases, real rates are positive.

Given that background it is interesting to observe the evolution of the Fed’s thinking over the past few years. The long term rate of  US GDP growth, which used to be thought of as around 2.7%, is now put at only  2% in the latest Fed projections, although that is still  deemed consistent with inflation picking up to the 2% target. The forecast Fed funds rate ( the Dot Plot) in the long term has also fallen, to 3.5% from around 4% a few years ago, which implies a 1.5% equilibrium real Fed Funds rate( 3.5% nominal less 2% inflation).

The Fed’s view on the timing in reaching this target has also changed appreciably; a year ago the median expectation was a  Fed Funds rate of 1.375% by the end of 2015 and that is now 0.375% (with only two meetings remaining this year).  Similarly, the current median expectation for official rates at end-16 is 1.375% against 2.875% twelve months ago. What is also striking is the distribution  of the forecasts for next year, with a range of -0.125% to 2.875%.

Equity markets did not react well to the FOMC leaving rates on hold, which implies that it is  the Fed’s nervousness about the short-term outlook that is dampening investor spirits, offsetting any positives from the absence of tightening. The Fed’s gloomier  longer term  view is  perhaps more significant , however, in that we are all Secular Stagnationists now it would seem.

 

Massive excess supply pushing oil prices down.

Energy , which accounts for almost 10% of the Irish CPI and  a slightly higher share of the equivalent EA index, tends to be the most volatile inflation component. This reflects the nature of crude oil  demand , which is very unresponsive to price in the short run and so small changes in supply can have a large impact , although the full  knock-on effect on the market price of fuel is diluted somewhat by the incidence of tax, which is high in many European countries, including Ireland. This works to dampen the effect of a sharp rise in crude prices and to reduce the gain to consumers following a large fall, although the impact on the CPI can still be significant if the move in crude prices is large enough.

That has certainly been the case in 2015; Irish energy prices in July were 6.7% lower than  the previous year with a similar  fall across the EA, helping to reduce overall inflation rates. For example, the annual  EA inflation rate in August was just 0.2% instead of 1.1% if one excludes the energy impact.

The consensus view, and one shared by the ECB, envisaged inflation picking up in the latter months of 2015 as the impact of weaker  energy prices dropped out of the annual inflation rate but that now looks less likely following renewed falls in energy and other commodity prices; the price of Brent crude had appeared to be stabilising  at over $60 a barrel in the early summer but started to slide in July, with the decline gaining momentum through most of August, to a low of under $43 at one point, levels last seen during the global financial crash in late 2008. Brent has recovered a little ground of late but that plunge, which was even sharper in euro terms, should translate in to another round of lower fuel prices and hence overall inflation rates- our  own Irish Petrol Price Indicator points to €1.31 a litre from around €1.43 a month ago.

What has precipitated such a slide in the price of crude?  Global economic activity is less energy intensive than it was but the International Energy Agency (IEA) still envisages world oil demand rising by 1.6 million barrels per day (mbd) in 2015, a significant pick up from the 2014 outturn. Weaker than expected growth in China could reduce that estimate but it seems clear that demand is not the main issue. Supply  would therefore  seem to be the driver  of the price collapse, and that is indeed the case, with some estimates putting the excess available in the market in q2 at some 3mbd, an extraordinary figure by historical standards,  and  helping to push OECD oil inventories to record levels.

One factor at work is the continuing rise in non-OPEC supply, which is put at around 1.3mbd in 2015, largely reflecting higher US output, including that from shale. Iraqi supply has also risen substantially over the past year (to record levels) and one might expect Saudi Arabia, the traditional swing producer in OPEC, to reduce production and hence supply from the cartel in order to support price. That has not happened , implying the Kingdom  is adopting a new strategy, perhaps with the aim of  impacting the future development  of non-OPEC supply, particularly from shale. Whatever the rationale the result is that  the world is awash with oil at the moment and few analysts envisage a  significant rise in prices over the next few years. Supply shocks are always possible, of course, which would change the outlook, but in the short term at least consumers are likely to receive another boost to purchasing power via lower fuel costs.