This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.
The U.S. Federal Reserve Bank has been directed by U.S. Congress to serve under a firm statutory mandate. This has 3 specific goals: maximum sustainable employment, stable prices and moderate long-term interest rates. With sustainable unemployment in hand -- defined as the highest level of employment that can be maintained while avoiding unstable inflation -- one might argue.
Current economic conditions in the U.S. are very close to targets. The household unemployment rate is hovering around long term record lows. Core consumer price inflation is below the Fed’s target of 2.0%. The latter was an explicit target set by former Fed Chairman Ben Bernanke in 2012.
In sum, one might argue. U.S. macro data is right where it should be.
Larry Summers compared the U.S. economy to personal health in an article in The Financial Times at the beginning of the year: “When people are fundamentally healthy, they do not yet know what will cause their death.” That means this: we might be closer to a U.S. recession than we think, too. Thus, a key question emerges, to critiquing these macroeconomic times: Does an interest rate cut at this stage make sense?
1) Low Consumer Price Inflation:
The graph above illustrates consumer inflation as measured by the Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE) Excluding Food and Energy, is the light green line. It barely crossed the 2.0% mark since the financial crisis, once in early 2012 and again in early 2018. You can also see how much the measure fluctuates when food and energy is included. Track the dark green line.
One could make the case: this low consumer inflation is ideal.
However, the Fed is not just concerned about core consumer inflation exceeding 2.0%. Weaker recent readings could also be a more malevolent sign: the U.S. economy is dangerously close to deflationary levels. This holds particularly true, if one is reminded about the amount of noise surrounding inflation measurement. This is partly why central banks have defined price stability not at 0.0% but at 2.0%.
In recent months, Fed officials have repeatedly expressed concerns about below target inflation. Weaker readings can indeed erode expectations of future prices increases. They can subsequently lead to a deflationary spiral of business and consumer price-setting behavior. This could hamper U.S. economic growth. Thus, providing a healthy buffer against deflation might be prudent. A little more Fed stimulus in July could prevent still lower real interest rates later.
1) Global Economic Weakness:
The U.S. economy has clocked in at stable growth rates over the last few years, within the boundaries of a +2.0% to +3.0% real GDP growth rate. Meanwhile, its household unemployment remained at record lows. However, in a globally interconnected world, the U.S. economy does not function in a vacuum.
Weakness in international demand will eventually cut more deeply into U.S. markets through various channels, in particular through shallower direct trade flows, and through forces in capital markets, unbalanced by policymakers trying to address them.
Since last June, uncertainty around trade policies has contributed mainly to heightened worries among business leaders across the globe. That held back investments the past 4 quarters. With an ongoing stalemate between the U.S. and China negotiators, it remains unclear whether a trade agreement will be reached this year, or is even likely before the 2020 election.
The Chinese can easily and rightly bet on a Democratic administration, given the Presidential approval figures that are out there. Thus, we will most likely continue to experience downside pressure on the U.S. economy, through dampened trade settlement expectations.
Fed President Jerome Powell has repeatedly brought up that weakness in international growth was one of the key reasons for this interest rate cut. Thus, it appears clear to us. The Fed is highly aware of the potential for weak global demand to slow down the U.S. economy’s momentum, even more.
2) Strength in the Greenback:
Frankfurt -- one of Europe’s financial centers and home to the European Central Bank (the ECB) -- will play a major role in FOMC meetings for the rest of the year. With the ECB’s policy rate at -0.4% and ECB President Mario Draghi’s outright comments about future easing, the Fed has likely been forced to succumb to downward global capital market pressure on its Fed Funds policy rate.
The influence of ECB rate decisions, present and future, became evident even before the recent global bond market reaction to Draghi’s statements. Vice Chairman Richard Clarida voiced these concerns. He stated it. There is a limit to what extent U.S. rates can diverge from global rates.
Currency wars are far from the Fed’s intended goals. On top of that, U.S. currency policy is not directly part of the Fed’s toolbox, but rather under the purview of the U.S. Treasury. Yet, it is an obvious concern. If the U.S. maintains elevated interest rates, an increase in inward U.S. capital inflows would raise demand for the U.S Dollar against other currencies.
FX can then subsequently alter U.S. open economic trade flows. Given the U.S. imports far more than we export -- an even stronger U.S. dollar and weaker non-U.S. FX crosses -- would further erode internal consumer price inflation, particularly on goods-sensitive areas.
This is important to underscore. A currency war is far from what the Fed intends. Its economists are highly sensitive to the potential danger of a downward spiral of currency depreciation. Yet one could ensue. Given the circumstances, it will surely be necessary for the world’s major central banks (the Fed, the ECB, the BoE, and the BoJ) to coordinate their efforts to prevent continuing international weakness.
For the rest of us – stock-buyers -- it makes the case. Be on the lookout for a change in the direction of FX crosses. Don’t get into non-U.S. stocks unless and until non-U.S. growth ticks up.
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