“Like it or not, the Fed is in the midst of a race to ease, and lagging only makes it more likely that policy rates will have to revisit the zero bound because a stronger dollar will put downward pressure on already below target core PCE inflation”, Deutsche Bank’s Stuart Sparks wrote, in a Friday note following Jerome Powell’s Jackson Hole speech and China’s retaliatory measures on $75 billion of US goods.
Sparks was reiterating a thesis discussed earlier this month. If the US economy continues to outperform relative to its trading partners and the Fed refuses to ease aggressively in the face of dovish pivots abroad, the dollar will remain resilient and the US will import disinflation, thereby making it even harder for the Fed to hit its mandate.
As we wrote last week, if you’re looking for reasons why the market is pricing aggressive easing from the Fed, you might think about it through that lens, rather than through the lens of a recession. That is, it might not be that the market sees something the Fed doesn’t in the data, “it could be that the market is associating a full easing cycle with a somewhat different scenario or set of scenarios that ultimately require much lower short rates”, Sparks wrote on August 16.
For Sparks, Powell’s speech provided a series of rationalizations for the Fed moving back towards the effective lower bound.
First, Powell enumerated the risks, including an acknowledgement of the relatively dour outlook for global growth, a reiteration of trade policy uncertainty and a reminder that inflation is subdued.
Second, Powell noted that running the labor market hot has not generally produced undesirably high levels of inflation. As Deutsche’s Sparks writes, “this acknowledges the flat Phillips curve, and is relevant because given a starting point of below-target inflation and headwinds from currency strength, the flat Phillips curve raises uncertainty whether even very robust growth can generate domestic inflation sufficient to push inflation back to target”.
So, theoretically, even if the Fed cuts rates sharply, the ensuing economic strength relative to the rest of the world could easily overwhelm any inflationary impact of pro-cyclical monetary policy – that is, the currency strength tied to economic outperformance could well lead to enough imported disinflation to swamp any inflationary impact from cutting rates.
Third, Powell remarked that “a lower r* combined with low inflation means that interest rates will run, on average, significantly closer to their effective lower bound”. If the market was looking for validation of a view for lower short rates, there it is.
All of that is bullish for rates and then there’s the tariff escalations. Sparks writes that “China’s 5% tariff on US oil imports, and President Trump’s statement that retaliatory measures would be announced on the same day, have exacerbated growth and inflation risks from international trade, as enumerated by Powell”.
Given all of the above, there is a pretty clear case to be made that US rates will need to fall back near the lower bound even absent a recession, although clearly, a recession would materially raise the odds of the Fed cutting rates to zero.
Deutsche focuses on the structural disinflation scenario, wherein rates have to fall “materially” in order to short-circuit the kind of dollar appreciation that could undermine domestic inflation further, especially in an environment where headwinds to global growth mean America’s trading partners are actively easing policy.
The bottom line, from Deutsche’s Sparks, is that “if Powell’s speech highlighted a path to zero rates, the latest escalations of the US/China trade dispute provide a shove in that direction, increasing the probability of a near term US recession and clearly the total probability of hitting the effective lower bound”.
Satirists have long suggested that one “solution” to a lot of Trump’s problems (including, by the way, his aversion to high oil prices), is simply to engineer a recession or a war. If we do get an ouright economic downturn, there’s no better “medicine” than a military conflict to get us out.
As far as how likely it is that we ultimately hit zero in the US, Sparks actually puts some numbers on that.
“With the rationalizing elements for a more aggressive policy response now introduced by Powell, and further trade dispute intensification, we think it is eminently plausible for markets to price a 75% probability or higher of reaching the zero bound”, he writes.
That might not be good enough for Trump, though. Earlier this week, the president said, in a tweet, that the US is “competing with many countries that have a far lower interest rate, and we should be lower than them”. To the extent he means Europe and Japan, zero would be too “high” for this White House.