Via Elliot Clarke at Westpac first:
The April/ May FOMC meeting saw the Committee hold firm to their constructive but cautious view of the economic outlook. That inflation’s underperformance of the 2.0%yr medium-term target was highlighted in the decision statement initially supported market pricing of rate cuts in late-2019 and 2020. However, in the press conference Chair Powell subsequently made clear that this miss is regarded by the Committee as transitory, and hence is of no consequence for policy.
On activity, the decision statement continued to characterise the labour market as strong – a view we wholeheartedly agree with given the 180k month-average gain of 2019 is consistent with a further decline in the unemployment rate from its already historically-low level of 3.8% towards 3.5%.
With respect to GDP growth, the change in the wording of the statement from “growth of economic activity has slowed from its solid rate in the fourth quarter” to “economic activity rose at a solid rate” is also positive, pointing to a belief that the March quarter deceleration in domestic final demand will prove temporary. Justifying this view, Chair Powell emphasised in the press conference that the partial data for consumption and business investment had picked up of late.
This commentary indicates that the FOMC’s view on domestic final demand is as robust as their overall GDP forecast from the March 2019 meeting – an above-trend 2.1% gain expected in 2019 – despite the soft March quarter detail.
Although it received little attention in today’s communications, it should also be noted that risks associated with financial conditions and the global economy have also dissipated in recent months.
Most notably, households have received twin-benefit from the marked reduction in the US 10-year yield (which determines the 30-year mortgage rate) from a high of 3.26% to 2.50% currently and the related strong rally in equity markets.
For business, there is also cause to be more comfortable over the outlook, with trade negotiations between China and the US remaining constructive and the IMF pointing to still-robust growth in the global economy over 2019 and 2020. Both views are in line with our own expectations.
With regards to inflation, the Committee’s decision statement certainly showed more concern, with core PCE inflation (excludes food and energy) said to have “declined” to now be “running below 2 percent”.
However, in the subsequent press conference, Chair Powell repeatedly made clear that core PCE inflation’s unexpected weakness was believed to be transitory and hence of no significance for the stance of policy for the foreseeable future.
Primary justification for confidence in the outlook for core inflation came from the Dallas Federal Reserve’s trimmed mean measure holding at 2.0%yr despite the PCE exclusion measure having fallen to just 1.6%yr. Chair Powell went on to highlight that the disinflation reported by core PCE came from a number of oneoff transitory factors as was the case in 2017 – after which core inflation rose to be in line with the medium-term target in 2018.
Looking ahead, we believe the underlying macroeconomic picture is supportive of core PCE inflation again returning to target. As above, momentum in the labour market remains robust and is set to sustain the wage growth uptrend of recent years. Along with above-trend activity growth, this momentum in wages should see underlying consumer inflation strengthen.
This view does not however mean that we foresee the FOMC turning hawkish. After years of inflation underperformance, with activity growth slowing back towards trend, and given global risks are still tilted to the downside, further rate hikes would only be warranted if inflation materially surprised to the upside over a protracted period.
We continue to see little risk of such an outcome and therefore of the FOMC doing anything other than remaining on hold for the foreseeable future – through both 2019 and 2020.
US growth is going to slow in H2 as the fiscal cliff hits but only for a few quarters and with 2020 an election year the spending usually flows. I can’t see the Fed cutting, therefore. But nor is there much reason to hike. Wages growth has been plateauing recently and it is questionable that there will be enough economic momentum to drive it much higher. Goldilocks is my call, for now at least.
Next up, we have Damien Boey at Credit Suisse on asset markets:
Overnight, Fed Chair Powell let slip his view that low inflation is “transitory”. He also suggested that he is not too concerned about asset price bubbles. Investors took this as a signal that the Fed is not about to ease just yet, and may even still be thinking about rate hikes (notwithstanding the official pause stance).
This is a big deal. In our recent article, we suggested that central bankers are now using volatility cuts, rather than rate cuts or balance sheet adjustments, as their policy instrument of choice. The advantage of this approach (if credible), is that the perverse tightening effects of rate cuts or asset purchases on savers can be avoided. But the disadvantage is that it is hard to maintain sufficient credibility to deliver long lasting volatility cuts.
In this context, we are surprised by Powell’s comments, but not surprised by the market’s reaction. If the Fed is willing once again to test the limits of its credibility, undermining its put, investors will respond in a non-linear way, by chasing quality. But if it can remain true to the put, the put could non-linearly support value, notwithstanding stretched valuations across asset classes. The key is that we are negotiating the variance risk premia – as distinct from equity or term risk premia.
The good news is that we think that the Fed will take notice of volatility and address the slip. Also, we think that the Fed has built a sufficiently high variance risk premia over the past few months, to give it room to make some “mistakes” and subsequently correct them. But the Fed does need to repair the damage quite quickly.
I agree there is no need to panic.