Clearly, developed market central banks could have done without the outbreak of a deadly respiratory virus just as the global economy looked set to regain its footing after being waylaid by a bruising trade war and the Fed’s ill-fated effort to normalize policy in 2018.
Policymakers did their best with the dwindling ammunition at their disposal last year, deploying precious rate cuts (think of them as scarce bullets or, if you like, the last couple of Xanax at the bottom of an almost empty bottle) in a bid to ease financial conditions that had tightened in the fourth quarter of 2018, and prevent the global manufacturing slump from spilling over into services and infecting labor markets.
Now, a year after Jerome Powell first tipped the Fed’s dovish pivot, the nascent recovery is imperiled by a pandemic, which on Thursday was declared an emergency of international concern by the WHO.
The Fed was caught somewhat flat-footed, which is understandable because there’s no way to predict when a deadly pathogen is going to crawl up out of a live animal at a wet market in China and spread among the locals.
Powell did his best to field questions about the outbreak during his press conference on Wednesday, but truth be told, there is no “plan” right now, and if the outbreak abates, none may be necessary.
But, assuming it gets at least a bit worse (and it already has, just over the past several hours), there are two channels through which it can operate on the economy, Deutsche Bank’s Aleksandar Kocic writes, in a note dated Thursday.
The first is a straightforward growth shock that engenders a broad-based, global economic swoon. But more likely, in Kocic’s view, is a situation where China’s economy is disproportionately affected versus the US. In that scenario, Kocic says “two very similar narratives could result, but with materially different implications for the evolution of the curve slope”.
Zooming in on the second narrative, Kocic conjures the dynamics outlined last year by colleague Stuart Sparks, who argued that recession or no recession in the US, the Fed may eventually be compelled to keep cutting rates in order to avoid importing disinflation via a stronger dollar in an environment where the US economy continues to outperform.
The irony is that, assuming Fed cuts work to bolster US growth, they could actually work at cross purposes with the Fed’s efforts to get inflation up to target. That is, the better the US economy performs against a backdrop of still-sluggish activity globally, the stronger the dollar and the more likely it is that the US imports disinflation.
The virus scare could increase the odds of that outcome playing out, especially if a renewed slowdown in China ends up working on the same pressure points as the trade war, as outlined in these pages Wednesday evening.
“Resilient US growth relative to China and economies with strong trade linkages to China (e.g. Germany) would still drive the Fed to ease, and plausibly to the zero bound”, Kocic writes, noting that “the crux of this argument is that growth differentials ultimately drive further broad USD appreciation, which puts downward pressure on inflation”.
He goes on to say that while it’s clearly the case that the Fed’s mid-cycle adjustment succeeded in easing financial conditions and stabilizing stocks, breakevens ” remain at the low end of the 2018-2019 range”.
In the context of the Fed’s ongoing policy review, Deutsche’s house view is that the unveiling of average inflation targeting will be accompanied by a “flattening of the Fed dots”, but the committee will still be compelled to cut again in 2021 in order to hit its inflation goal (i.e., simply committing to keeping rates low won’t be enough).
That base case is, of course, subject to change in the event inflation dynamics worsen (on the downside, obviously) and hasten or bring forward rate cuts. “As a thought experiment, it strikes us that the announcement of average inflation targeting would be unconvincing in the presence of an inverted curve and very low breakevens, all the more so if the ‘exclamation point’ for the strategic review were almost anything other than a rate cut”, Kocic notes.
The vexing quandary for the Fed in this situation is that, assuming rate cuts have even a marginally positive impact on US growth, but the Phillips curve remains flat and the rest of the world continues to underperform economically, easing would amount to running in place (at best) as a stubbornly strong dollar keeps importing disinflation.
“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 disinflation imported by dollar strength that is driven by that same above trend growth”, Deutsche’s Sparks wrote last month. “In these circumstances, ironically, the net result could, perversely, be that above trend growth lowers inflation!”, he went on to exclaim.
This exercise in tail-chasing would presumably dead end at the ZLB. The Wuhan virus, were it to reinforce the trade war environment wherein China and Europe and other key economies underperform the US, could exacerbate this dynamic.
“If the growth impact on the US is minor, a transitory [curve] inversion would resolve into bearish steepening, while in the [above] scenario, growth might stabilize but there would be appreciable risks that nonetheless the curve could remain inverted because inflation doesn’t recover”, Kocic says. That, in Deutsche Bank’s view, is “consistent with greater easing in an attempt to preclude further dollar appreciation”.
As Sparks put it back in August, this “smacks of inevitability”.
The dollar hit a seven-week high earlier this week.