By: Suyash Choudhary
We had observed in February as to how global policy seemed to be shifting, responding to the synchronized slowdown narrative on global growth (https://www.idfcmf.com/insights/policy-puts-start-re-emerging/). With the European Central Bank (ECB) and US Federal Reserve (Fed) policy meetings since then, these initial ‘put’ options have now been significantly strengthened. Both these central banks ended up sounding much more emphatically dovish than was expected. The ECB downgraded growth and inflation forecasts, committed to keeping interest rates unchanged at least through the end of 2019, and launched a new series of quarterly targeted longer-term refinancing operations (TLTRO-III), starting in September 2019 and ending in March 2021, each with a maturity of two years.
The template was similar for the Fed where growth, employment and inflation projections were also downgraded. The collective assessment of members suggests no further rate hikes in the current year and just one more in 2020. To put this in perspective, the collective forecast as recently as in December was for two additional hikes in 2019, and one more in 2020. Further the Fed will start slowing the pace of balance sheet run offs from May and cease reductions in balance sheet altogether at the end of September 2019. With this the Fed has managed to throw a dovish surprise to markets in its second successive meeting. There is a view that perhaps it has been a shade too quick in locking itself into this new dovish stance, especially as the outlook on the economy still remains relatively robust and the theme rather is that an above trend growth is converging towards trend.
Our best guess is that this turn in the Fed is rooted in evolving inflation expectations. A hint towards this was given by the Fed Chair in his post policy conference where he seemed to suggest that even after almost 10 years of economic recovery inflation expectations have remained relatively muted. We include below a quote by Chair Powell from the most recent post policy press conference:
“It’s one of the major challenges of our time, really, to have inflation, you know, downward pressure on inflation let’s say. It gives central banks less room to, you know, to respond to downturns, right. So, if inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to, you know, keep inflation at two percent, which gives us some room to cut, you know, when it’s time to cut rates when the economy weakens. And, you know, that’s something that central banks face all over the world, and we certainly face that problem too. It’s one of the, one of the things we’re looking into is part of our strategic monetary policy review this year. The proximity to the zero lower bound calls for more creative thinking about ways we can, you know, uphold the credibility of our inflation target, and you know, we’re open-minded about ways we can do that.”
U.S. consumers’ inflation expectations
The graph above charts various measures of consumer inflation expectations over longer periods of time. What is noteworthy is the recent dip in expectations despite the US economy having grown substantially above trend only last year. This, then, seems to us as the most telling reason behind the Fed’s remarkable policy U turn. More generally, and as also gleaned from the comments above, developed market (DM) central banks are only too aware that their policy toolkits are asymmetric: there is much more scope to address an upturn in inflation / growth versus a downturn.
U.S. yield curve
The second graph charts the evolution of the US yield curve over the past year. As can be seen, there has been a remarkable flattening of the curve with parts of the curve now being inverted for the past few months. While the significance of curve inversions continues to get debated, it is definitely a market signal that the Fed may have found difficult to ignore as well.
Finally, recognition of a synchronized slowdown may very well herald a renewed phase of competitive currency depreciation. It is to be noted that this is never explicitly acknowledged by most central banks. Rather, a relatively strengthening currency feeds into policy decision making via a relative tightening of financial conditions. So far with the Fed actually hiking into a strengthening economy, a strengthening US dollar was an outcome it may have been happy to accept. Indeed, the whole point of hiking rates and running off the balance sheet would have been to net tighten financial conditions. However, this may no longer be the case going forward. Thus the Fed turn may also partly be owing to a desire to not allow financial conditions to net tighten going forward.
Major DM central banks turning dovish has green-lighted renewed robust investor allocations to emerging markets (EMs). This also provides EM central banks room to turn more accommodative without worrying about currency pressures. This being the backdrop, India itself has a soft growth – inflation set up for now and a new governor who seems to have a much stronger reaction function. This makes for a continued bullish signal for quality bonds.
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