A week with a policy update from both the Fed and the ECB can beat the best TV series plot, even that of BBC’s excellent ‘Line of Duty’. The episode this week could have been entitled ‘Whatever it takes (Just in case)’.
For months the Federal Reserve has been bullied by both POTUS and the financial markets. The U.S. government has been implementing some fiscal policy tightening through the raising of trade tariffs and expecting monetary policy to compensate for any economic disruption. The markets have not been afraid of challenging the Fed either, ganging up with Mr. Trump: rarely was the delta between the market’s funds rate expectations and those of the Fed (as expressed by the dot plot) been so high ahead of an FOMC meeting.
Investors used to position themselves by asking themselves what the Fed should do given the economic circumstances. During Mr. Powell’s chairmanship and until recently, they transitioned to the trickier question as to what the Fed will do, as opposed to what it should do. Recently they have been attempting to tell the Fed what to do: implement a pre-emptive or ‘insurance’ rate cut to compensate for the potential impact from the trade dispute.
Meanwhile, by being provocatively dovish and unexpectedly close to another ‘whatever it takes’ moment this week, the ECB poured some oil on the fire by putting some upside pressure on the USD. As a parting gift, Mr. Draghi has de facto responded to a trade war with what can be interpreted as a currency war, following the steps of the People Bank of China which was born in ‘whatever it takes’ mode.
In this context, the Fed had little room to maneuver on Wednesday. So it capitulated. Back in March, low inflation was not a concern at all since deemed to be transitory according to Mr. Powell. It suddenly is a huge deal. More generally, the base case scenario for the U.S. economy remains healthy: A GDP growth rate above potential for the coming years, a job rate at a record low, ISMs above 50. But the focus is now on dealing with uncertainties, i.e. risk management. The Fed communication suggests it is having its own ‘whatever it takes’ moment – just in case – with the debate now shifted to how much to cut in July rather than whether to cut at all.
Ten years ago the central banks worked together to lift the world out of the Great Financial Crisis. 2019 may be remembered as the year when that harmony all but disappeared. These are not glorious times when considering the geo-politicization of monetary policy around the world. Since the costs of this regrettable evolution are not quantifiable today, there is nothing to prevent the stock markets from celebrating the central banks’ easing bias. But the long term implications may be less innocuous.
What is the path out of this mess? Two things must be acknowledged to pave the way for a global economic peace-making process: First, that the U.S. is fully entitled to revisit the rules of global trade, having sponsored it for decades to export capitalism at the expense of a massive trade deficit. Second, that in any lasting economic war the United States of America wins. Ten times out of ten, and by a wide margin when considering relative economic might, dynamism and accessible technology. There is no basis for a fight. Instead, the U.S. trade partners should sit down and negotiate in good faith a new global trade deal.
The next central banks episode will be released at the end of July. There will be sneak previews and maybe even spoilers until then, possibly triggered by the G-20 next week. It is an entertaining show. No subscription needed – it is free. But unfortunately it is no fiction.