It’s a thesis as intuitive as it is elegant – and if there’s elegance in simplicity, there’s perfection in intuitiveness.
Deutsche Bank’s Stuart Sparks and Aleksandar Kocic don’t quite give themselves that much credit for their view on the pseudo inevitability of additional Fed cuts, but last year, Sparks did say the setup “smacks of inevitability”.
If you assume 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 in an environment where the Phillips curve is flat and economies outside the US underperform. The better the US economy performs against a backdrop of still-sluggish activity globally, the stronger the dollar is likely to be, and the more likely it is that the US imports disinflation.
Any shock which serves to undermine growth outside the US more than it affects the economy stateside, will exacerbate this dynamic. In that sense, the coronavirus epidemic counts the same as the trade war.
Sparks and Kocic spend considerable time discussing this in their latest note, dated Friday. Here is how they begin:
US policy settings are excessively tight, in our view. Broad dollar appreciation has now proceeded to the extent that it is highly likely to cause a material change in the Fed’s outlook. Importantly, however, that change is likely to come in the inflation outlook, not in the growth outlook. The distinction is not merely semantic. Indeed, part of our argument is that because the Phillips curve is flat, even an acceleration in growth to above trend levels could leave inflation mired below target.
If you’ve followed the evolution of this argument over the past six or so months, that’s really all you need, as it neatly captures the gist of what I once called the “ultimate in ironic, tragicomedic Fed outcomes”.
Sparks summed it up in December with a colorful passage that suggested the implications of his own work were amusing even to himself. “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”, he said, before exclaiming that “In these circumstances, ironically, the net result could perversely be that above trend growth lowers inflation!”
It’s not hard to understand how the coronavirus situation has the potential to exacerbate this situation. For one thing, the epidemic has created acute jitters about global growth, which, in turn, raised concerns about demand destruction in commodities. Cue another catalyst for the dollar.
“Because the Phillips curve is flat, inflation is more likely to be driven by factors other than the output gap [and] we contend that the key driver for the inflation outlook at present is the dollar”, Sparks and Kocic go on to write, emphasizing that they’re not making an argument centered around growth. This is all about inflation.
“The dollar is relevant through the channel of inflation expectations”, they note, adding that “perhaps the most obvious way for this to be so is the effect of dollar strength on commodities, particularly when external growth is fragile”. Needless to say, inflation expectations haven’t exactly been what one would call “buoyant”.
Now, consider two additional key points. First, Sparks and Kocic write that “in spite of 75bp of easing during the ‘mid-cycle adjustment’, the dollar has returned to the levels which preceded each of the 2019 rate cuts”.
That is disconcerting, and although he hasn’t voiced it in anything that remotely approximates language appropriate for an economics classroom, Donald Trump has delivered a crude version of the same point on countless occasions on Twitter.
At the same time, the insurance cuts did wonders to shore up stocks and ease financial conditions, but breakevens appear stuck.
As Kocic and Sparks put it, “the implication is that absent easier policy, ongoing dollar appreciation will continue to push US inflation and inflation expectations lower, further from the Fed’s target”.
Meanwhile, rate differentials and foreign QE are having an effect too.
Deutsche adds the following color, which helps bring it all together:
ECB and BOJ QE and NIRP continue to drive capital offshore, much of which is flowing into US assets. With these structural flows remaining in place, moderate changes in growth differentials and flight to quality flows into US assets can push the dollar to and past critical levels. Note that flight to quality driven dollar strength and falling commodities and risk asset prices are prone to local circularity.
The overarching point here (in case it’s not clear enough) is that if the Fed hopes to extricate itself from a situation where importing disinflation becomes increasingly inevitable, it will have to cut rates. Probably several more times.
The necessity of this is amplified by the forthcoming announcement of the results of its policy review. If inflation expectations are still stubbornly low by then and the curve stubbornly flat, it’s hard to see how an announcement about a new approach to inflation targeting would be credible without adding some oomph to it with a rate cut.
And that brings us neatly to the conclusion from Kocic and Sparks. To wit:
However, while a single cut might usefully communicate Fed commitment to achieve its inflation target if a cut were not otherwise warranted, the issue at present is that the curve is inverting, the dollar is appreciating rapidly, and breakevens have seemingly lost their tether to core CPI. The coronavirus threatens asymmetric impact on Asia – with clearly negative implications for Germany. The latest data suggest growth differentials still favor the US, and for this reason external investors still appear to prefer US assets. Rate differentials versus the NIRP economies remain wide. Fed cuts [may] be required to “sell” the results of the policy review, short circuit upward pressure on the dollar, and stabilize inflation expectations.
Coming full circle, it does in fact feel intuitive, inevitable and perhaps even fatalistic.