“I walk a lonely road… “
Boulevard of Broken Dreams, Green Day
Last week, we questioned the clear market consensus view of US exceptionalism - at least in terms of the recent market desire to extrapolate (significant) US growth outperformance.
At the very least, we questioned the market view in terms of taking into account the recent productivity gains and immigration flows (pushing up the equilibrium growth rate in the US and the breakeven employment gains - essentially stating that higher growth and, more specifically, higher job gains are not inflationary if they have only risen to new (higher) equilibrium levels).
On the flip side, we questioned the extrapolation of the recent European weakness and disinflation, despite the growing signs of a bottoming out of growth declines in Europe and China.
Bigger not Tighter
For instance, the updated Fed SEP projections for growth in March suggest an equilibrium growth rate at around 2.4% (up from the previously accepted 1.8% - as a function of higher productivity).
On the employment front, there is a similar phenomenon. Higher immigration likely means that the breakeven rate of job gains is higher than before; essentially, this means that the rate at which the US can generate jobs without creating a tighter labour market is higher.
From my perspective, it is thus clearer that higher GDP prints (at least up to the new equilibrium growth rate of 2.4%) do not indicate a need for higher rates. Similarly, a higher job growth rate is not indicative of a tighter jobs market or higher wage inflation.
Conversely, in nominal terms, the bar is significantly lower for rate cuts than would be the case without factoring this in. All of this is consistent with the phrase Powell used at the March FOMC press conference, that the US economy was “bigger, not tighter”.
The Fed retains a dovish bias
In essence, what we describe above amounts to an asymmetric dovish bias from the Fed. Interestingly, going into this week’s FOMC meeting, expectations were biased towards a more hawkish narrative, following the recent upside surprises to US jobs and inflation prints (even if the Q1 GDP print surprised to the downside - this ‘miss’ was discounted by the market as a transitory decline in net trade and inventories).
What about Growth?
Recently, in this piece, we have also discussed the pressures from higher prices and higher rates and the inconsistency of commentators extrapolating prices and rates higher at the same time as growth. From our perspective, tightening financial conditions at the consumer level, as a function of higher prices and rates, makes growth significantly more vulnerable going forward.
Indeed, the rationale for markets discounting weakness in the Q1 GDP print was that the underlying demand component was running in the vicinity of 3%. However, this number (and equally the stronger-than-expected retail sales data) is a value series - or, in other words, buying the same amount of things at a higher price produces growth.
Personally, I see this as a troubling backdrop in the US, but one that should be watched very closely. It is not clear to me that the US consumer is as strong as the data suggests (even though there have undoubtedly been positive wealth effects of the recent market evolution).
Indeed, I would argue that the consumer is having to run faster to stay the same. This week's much weaker-than-expected consumer confidence number emphasises this potential frailty.
Policy remains restrictive
Going into the FOMC meeting this week, there was a clear concern (or view) from markets that there would be a shift in the symmetry of the policy reaction function from the Fed, following a series of higher inflation and (in some data series’) growth readings. However, this concern proved misplaced, for now at least.
Despite the Statement having added the sentence that there has been a “lack of progress towards the committee’s 2% inflation objective” and Powell clearly stating that “inflation is still high”, the economy “resilient” and that labour demand continues to outpace supply (despite recent immigration trend), the overall narrative was dovish. Powell stated that it is “unlikely that the next move is a hike” and that expectations at the Fed remain that over the year, inflation will continue to decline - “the evidence shows pretty clearly that policy is restrictive and is weighing on demand”... “we believe, over time, it [the current policy rate] will be sufficiently restrictive”…
Essentially, the dovish bias was retained, and the announcement of a bigger than expected QT taper all skew dovish from a market perspective, and thus, for now at least, markets have priced out the prospect of rate hikes, giving bonds, risk assets a lift and providing a headwind to the USD.
The Narrower, Higher Path
During the press conference, Chair Powell was asked on several occasions to place a probability on the prospect of a more persistent inflation path or higher growth that would force the Fed to raise rates. Powell was clear that he would not get into debates over complicated theoretical developments or their probabilities; rather, the Fed is thinking about the future in terms of different paths the economy might take.
“There are paths to not cutting and there are paths to cutting. It’s really going to depend on the data”.
The path may be narrower, and indeed higher (certainly relative to expectations at the start of the year). However, high narrow paths are far from risk-free.
Indeed, for the last few weeks, we have highlighted our thoughts on the impossible triangle (as we see it) of higher inflation, higher rates and higher growth expectations in the US. Recently, we have seen more conflicting data in the US (not least the consumer confidence this week, GDP disappointment last week and a weaker Payroll report to close this week).
The Long & Short of it
The backdrop remains complex for global financial markets, but we maintain the view that disinflation and growth moderation likely remain dominant. With US policy significantly in restrictive territory (and as we have argued, signs of frailty starting to appear at the consumer level), a series of rate cuts will likely be needed not just in the eurozone and UK but also in the US.
Indeed, it is very possible that the markets pricing of a higher narrower path in the US helped to shape the risks to the consumer going forward.
You could say that extrapolated expectations of US outperformance have created not so much a narrow path, but a boulevard of (potentially) broken dreams!
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