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Fed Cutting Rates To Zero ‘Eminently Plausible’ After Friday’s Events, One Bank Says

If Powell's speech rationalized a path to the lower bound, the tariff escalations "provided a shove in that direction".

“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.

Read more: Recession Or No, The Fed Has To Cut Rates Aggressively

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.

(Deutsche Bank)

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.


 

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6 comments on “Fed Cutting Rates To Zero ‘Eminently Plausible’ After Friday’s Events, One Bank Says

  1. This is treading on uncharted territory…. I love the context H…..presented this set of scenarios with…Strangely though this may all come to pass and a rewrite of the Post WW2 economic rules ( including unilateralism and globalization) will be required to right this ship….Maybe this time is different like some suggest.!! Truly a weekend ponder is here again….

  2. Disinflation? Tell that to a family wanting to buy a home, send their kids to college, or pay for medical treatment…
    deep populist resentment is inevitable until the dual bubbles in equity and bonds are pricked OR wealth is “re-distributed” from the haves to the have nots…..
    the longer the ones in power try to postpone the inevitable “cure” the greater the ultimate “pain”…

  3. The Fed has a dual mandate, employment and price stability. The 2% inflation goal is a number that the Fed pulled out of thin air and is NOT price stability. A small amount if deflation on imported goods will not cause any significant price deflation overall.

  4. Inflation data has been screwed up for many, many decades. Many studies have been done on the inaccuracy of data scanning by consumers who are paid to scan their chaotic shopping experiences and then the random chaos of retail prices, sales, coupons, promotions, just in time pricing and of course the entire era of online shopping and Big Box discounting. Measuring inflation is a farce with current and past proceedures!

    Mis-measuring Inflation with Inaccurate Consumer Data

    One explanation of these puzzles is that inflation is mismeasured because of changes in the retail sector. Specifically, this theory posits that by offering lower prices, Amazon.com and other e-commerce outlets in the last 10 years or so have exercised a strong downward pressure on prices
    similar to what was experienced in the 1980s and 1990s with the rising dominance of Walmart and other discount retail chains (Figure 1).

    First, central banks may have to recalibrate their
    targeted measures of inflation. If pass-through for online prices is as high as it is for food and energy
    prices, one could imagine that, in the limit, the core inflation measure would become CPI All Items
    Less Food, Energy and Amazon.

    Since statistical agencies appear to show little appetite to gather price quotes and volumes of sales for e-commerce, central
    banks should fill in this void. Having such data will help us better understand the nature of online markets and adjust policies accordingly.

    https://www.kansascityfed.org/~/media/files/publicat/sympos/2018/papersandhandouts/825180814gorodnichenkoremarks.pdf?la=en

    • Interesting POV. While you alluded to the Walmart effect P.A.(Pre-Amazon), you didn’t have the temerity to mention that the Walmart effect, albeit aided by technology, suppy chain optimization, and purchasing power was largely attributable to cheap Chinese imports (CCC = Cheap Chinese Crap). The quality of CCC has improved largely by copying, reverse-engineering, and/or seizing Western IP has now morphed into the Amazon effect as well. While I’m not a Trump acolyte, I think this is why there’s support on both sides of the aisle to go after the PRC’s subsidized exports (and manipulated currency) to America

      • Harvey Cotton

        China subsidizing their exports means that American consumers are getting their products artificially cheap. Domestic competitors then have to either go up the value chain, use marketing to change the culture and justify the higher prices, or cut prices. The incomes and wealth of the corporate officer class shows that there are some margins there available for reduction. Multinational corporations that go into China know that they will either have to share their intellectual property in order to gain access to the Chinese market, or that China may not have the strongest copyright protections. If, knowing that, they still make the decision to open shop in China, that is on Corporate America and not China.

        Also, the United States, which has been a prosperous and developed country for over a century, still subsidizes its exports and manipulates its currency, and has been stealing foreign technology at least since Samuel Slater – unless you think all of that N.S.A. infrastructure exists only to intercept chatter in Afghan caves and Iraqi pick-up trucks.

        The fundamental problem is that businesses that are even nominally American are incentivized to maximize profit, not be nationalistic – even though they are allowed to influence American politicians and policy. It is too easy to blame China for things that benefit American businesses, consumers, and politicians.

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