For months, Deutsche Bank’s Stuart Sparks has argued that the US is at risk of importing disinflation and that, ultimately, the Fed could be forced to cut rates more aggressively than they’d like regardless of whether a US recession comes calling.
The thesis is simple. The world is struggling to stave off deflation, and between comparatively hawkish US monetary policy, favorable yield differentials and stronger growth relative to the rest of the world, the dollar will be prone to appreciation.
That, in turn, could lead the US to import the disinflationary impulse, thereby undercutting the Fed’s inflation narrative, and forcing the FOMC to cut rates aggressively in order to tame the dollar.
Whether he knows it or not, Donald Trump has essentially made the same argument at various intervals over the past year.
Although Trump is correct to worry that the monetary policy divergence between the US and its trading partners will bolster the greenback and thereby serve as a drag on the domestic economy (especially the manufacturing sector, which he pledged to resurrect), he conveniently fails to mention that when it comes to explaining why growth outcomes abroad have suffered (and thereby why foreign central banks have been compelled to cut rates), the trade war he instigated is the culprit. Further, when it comes to explaining why the Fed was forced to lean hawkish in 2018, thereby supporting the dollar, Trump never acknowledges that his plunge into late-cycle fiscal stimulus raised the specter of an economic overheat.
In any event, in his year-ahead outlook, Deutsche’s Sparks reiterates his thesis, and casts a wary eye at the notion that the rate cuts delivered since July will be sufficient to bolster inflation.
“The Fed’s narrative is that the downward 75 bp mid-cycle adjustment of the funds rate leaves policy rates accommodative, strong labor markets suggest that consumption can offset weaker investment in prolonging the expansion, and that inflation remains broadly consistent with price stability, though at the low end of the acceptable range”, he writes, before conceding that although he has “a low degree of confidence in real-time estimates of the neutral level of short rates, for the time being the Fed’s mid-cycle adjustment has succeeded in dis-inverting the yield curve, and similarly for the time being seems to have halted the appreciation of the dollar”.
Long story short, Sparks does not believe that what he calls a “modestly accommodative level of short rates” is going to cut it. (Get it? “Cut” it”?)
“Low short rates ease financial conditions and contribute to asset price inflation [but] even if easy financial conditions and buoyant risk asset valuations are supportive for growth, the fundamental problem is that the Phillips curve remains stubbornly flat”, he writes.
It’s a familiar refrain – indeed, there’s a sense in which it’s all that matters for policymakers going forward. “The linkage between growth relative to trend and inflation remains weaker than before the financial crisis”, Sparks goes on to say, adding that “both market and survey-based metrics of inflation expectations remain near the low end of historical ranges, and at the low end of the range the Fed deems consistent with price stability”.
If the Phillips curve is “broken”, one of the main transmission channels between low rates and inflation is severed. But beyond that, the currency channel poses a particular risk, as noted above. Sparks underscores this. To wit:
Over the course of the last roughly 18m divergent policy and market rates between the US and other major economies, in conjunction with growth differentials favoring the US and steady USD inflows, have contributed to steady dollar strength. Currency strength is the classic means of importing dis-inflation from a global environment of slow growth and undesirably low inflation.
But that’s not the punchline. Rather, the punchline is that if you follow the logic presented here at the outset, you’re forced to ponder an absurd (or maybe “tragicomedic” is the better adjective) scenario where, because the price Phillips curve isn’t functioning “properly”, better growth outcomes actually end up leading to lower and lower inflation. To wit, from Sparks:
The fundamental risk for the Fed’s inflation narrative is that the flat Phillips curve suggests that even above trend growth might not generate enough domestic inflation to offset dis-inflation imported by dollar strength that is driven by that same above trend growth. In these circumstances, ironically, the net result could, perversely, be that above trend growth lowers inflation!
Crucially – and to appreciate how amusing this really is, you have to understand this part – Sparks is not necessarily calling for a recession.
In fact, he’s implicitly suggesting the opposite.
That is, if the Fed’s trio of rate cuts ends up stabilizing the US economy, but the rest of the world continues to struggle, absent signs of life of the price Phillips curve, better US growth outcomes will end up pushing inflation lower via the currency channel.
“Note that this is not a forecast of recession, the entire point is that it is no longer reliably appropriate to conflate growth and inflation outcomes”, Sparks says, before exclaiming that “In fact, we would place a reasonably high probability on a scenario in which growth recovers to trend and inflation falls anyway!”