It’s Thursday and former FX trader Mark Cudmore thinks you’re underestimating the Fed’s capacity to tighten policy.
Sure, realized inflation has yet to show a sustained move above target and yes, recent price action across the commodities complex suggests we’re quickly headed into a deflationary death spiral thanks, somewhat ironically, to the PBoC’s own tightening efforts, but according to Cudmore, it’s all about financial conditions.
And you can probably surmise by the fact that the dollar hasn’t exactly been the “sure thing” trade everyone thought it was going to be in 2017 and the fact that global equities continue to push to dizzying heights, things are looser than they’ve ever been.
And then there’s the overheating labor market which, subdued inflation be damned, screams “pull the damn trigger.”
Of course if you hike into an environment where inflation is still subdued and growth is lackluster, you’ll likely end up bear flattening the curve but don’t worry, Cudmore says that’s not indicative of a policy mistake.
Read more below and do note that while Cudmore may be correct to say that markets aren’t pricing things correctly, there’s not exactly a dearth of bearish bets here despite recent covering of long end shorts…
Via Bloomberg
The Fed’s room to tighten is being underappreciated. The market adjustment, when it comes, will be felt more in the front end than the long end of the U.S. rates curve.
- Rates markets are only pricing one-and-a-half more hikes in 2017. That seems reasonable in the blinkered context that inflation shows little sign of accelerating out of control. However, monetary policy analysis needs to be updated
- Amid an excess of global liquidity, inflation is being dominated by macro factors. Commodity prices and technological innovations, rather than marginal short-term interest rate adjustments, are topmost in people’s minds
- The last two Fed rate hikes had no sustained tightening impact. In fact, financial conditions in the U.S. are the loosest they have been in almost three years, and approaching the extreme of the historical range going back 27 years
- This suggests that the Fed has plenty of room to tighten policy. Why wouldn’t they take steps to normalize while they can get away with it?
- Ignoring the fact that this yet again argues for a rethink of inflation targeting and using short-term interest rates as the primary policy tool, it’s important investors don’t misinterpret the rationale and implications of any tightening
- The next Fed moves won’t be driven by accelerating growth or runaway inflation, so the yield curve shouldn’t steepen. But a subsequently flatter yield curve shouldn’t be read as signifying a policy misstep
- This is just the way of the future. There is extremely abundant liquidity globally due to the expansion of central bank balance sheets. While that’s the case, old economic analysis frameworks are outdated and inadequate
Oh dear
I suspect it’s Cudmore who is in fact ‘outdated and inadequate’ – it’s now accepted in the kind of heterodox thinking that anticipated the GFC that the scope & scale of liquidity creation embarked on by policymakers since the GFC is ultimately likely to cause the next liquidity crisis – even the Fed’s own researchers have acknowledged this.