Macroeconomics

We Found Love in an Unchanged Rate

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We Found Love in an Unchanged Rate

There is an old saying among traders that the Fed doesn’t change monetary policy during a presidential election year. 1 1 Close Here’s a pro tip for the Fed: if you don’t know who your boss will be next year, you shouldn’t do something to potentially upset her. Like many sayings among traders, it is completely false. A quick look at official records reveals that the Fed moved its target rate prior to elections in 1992, 1996, 2000, 2004 and 2008. The Fed isn’t afraid to announce unorthodox measures during an election year either – it extended Operation Twist and announced QE3 in 2012. 2 2 Close US Fed opts to extend Operation Twist,” Financial Times, June 20, 2012. , 3 3 Close FOMC Statement, September 13, 2012. That leaves only one year since the Reagan administration without a move: 2016, although the Fed hiked in December of the previous year and again a month or so after the election. 4 4 Close The Fed also moved rates during election years in the Reagan administration. So now that we’ve debunked that horribly misguided myth, let’s get to the point of this Wrap-Up: The Fed is unlikely to move rates this year because it’s an election year. Bet you weren’t expecting that. 

Although the Fed Chairman and its governors are appointed by Congress, they act independently in the best interest of the economy, at least in theory. The Fed is tasked to set its target to the correct rate to meet its mandate of stable inflation and full employment. Despite what a former Regional Fed President might suggest, it does not endorse specific candidates in elections. 5 5 Close “The Fed Shouldn’t Enable Donald Trump,” Bloomberg Opinion, August 27, 2019. It should take the same actions in an election year that it would at any other time. Many Fed members pride themselves on being free of political influence. They claim to act purely on economics. 

This year, the economics don’t present an overwhelming case for moving rates. Even though unemployment is low, it has not led to strong wage growth. Inflation was low in 2019, which means there isn’t much pressure to hike rates. In fact, the Fed has been more concerned about persistently low inflation – after almost eleven years of an expansion, inflation is struggling to get to target. But the Fed sees inflation rising closer to its target over the next few months. 6 6 Close “Rents Lift U.S. Core Inflation; Weekly Jobless Claims Rise Modestly,” Reuters, February 13, 2020. This is a quirk of the general preference for year on year numbers. They reduce the effects of seasonality because they include the entire year, but what happened exactly a year ago can have a big effect on the current number. They don’t completely eliminate seasonal issues. For example, if Thanksgiving is later in the month, it can move consumption from November to December. And you may recall that the Fed cut rates three times last year which its members described as precautionary. 7 7 Close “Fed ‘insurance’ cut gets cold shoulder from markets,” CNBC, September 18, 2019. That makes the need for immediate cuts less urgent.

In his testimony to Congress on Tuesday and Wednesday, Powell summed it up, “As long as information about the economy remains broadly consistent with this outlook, the current stance of monetary policy will likely remain appropriate.” 8 8 Close Powell testimony: Fed is ‘closely monitoring’ coronavirus for hit to China and the world. He made it clear that he did not consider the T-bill purchases to stabilize the repo market to be a change in monetary policy. He spent much of the Q&A with the House of Representatives answering obscure regulatory questions and explaining why he was at a party with Jeff Bezos. He seemed as likely to be asked about Eminem’s surprise Oscars appearance as he was about monetary policy. 9 9 Close The people in Congress looked about as excited as Martin Scorsese listening to “Lose Yourself.” I wonder if the Fed testimony drew more viewers. As annoying and irrelevant as these questions may seem, Powell was probably relieved not to be pressed about interest rates. 

As much as the Fed is concerned about inflation and growth, its members may be more concerned about its independence. Fed members believe that political pressure leads to bad monetary policy decisions and eventually, in the worst-case, currency debasement. 10 10 Close Economists fear that if the government controls monetary policy it will fund its debts by printing money or through easy credit, which will debase the currency. President Trump’s attacks on the Fed and its monetary policy may seem anachronistic, but Fed members could perceive them as a real threat to their independence. The Fed does not want to be an issue in the election, and certainly does not want to be seen as making decisions which affect its outcome. That could lead to more direct congressional or executive oversight of Fed decisions. 

Chairman Powell has been making the rounds with members of Congress to help shore up the Fed’s standing. He seems to be having some success with his open market charm operations. President Trump has toned down some of his criticism of Powell, although he is still pushing for lower rates. 11 11 Close He has called for negative rates and QE. “Trump again pushes negative interest rates, but Kudlow says they don’t work,” CNBC, January 21, 2020. He could get his wish in spite of himself. If there was a big negative shock in which growth weakens or inflation falls, it could force the Fed’s hand. Powell acknowledged as much when he said, “if developments emerge that cause a material reassessment of our outlook we would respond accordingly.” Powell can sound like the perfect combination of a lawyer and economist.    

Powell only briefly mentioned the coronavirus as one such development. If the coronavirus spreads further and disrupts economic activity around the world it could constitute a material shock to the economy. On the other hand, listening to Powell, it doesn’t seem like there is much that could make the Fed hike rates – even moderately higher inflation is welcome. Still, barring any disasters, the most likely outcome is rates staying on hold. This election year is different from any in the past thirty years in that the Fed may feel that it has something to lose if it is drawn into it. They want us to expect nothing from them, and that is what they are most likely to deliver.  

 

What We Are Watching

Eurozone PMIs (Friday)

The outlook on the manufacturing sector in Europe is at a crossroads. With the recent release of extraordinary declines in industrial production across the largest European economies, some forecasters have moved to expect a notable slowdown in European growth. However, these hard data are at odds with the recovery observed in manufacturing PMIs in December and January. The disconnect may be resolved next week with the release of a new round of Manufacturing PMIs for Europe. Not only will the release come amid conflicting signals in European data, it will also be the first survey to show the effects of the coronavirus outbreak on manufacturing sentiment in the region. In this context, next week’s PMIs are particularly important to assess the state of the European economy. A downside surprise may prompt rallies in safe-haven government bonds, sell-offs in equities and rising expectations of stimulus from the ECB. A sharp disappointment could also support hopes for fiscal stimulus, particularly in Germany, where there is room for fiscal easing and is only held back by political considerations which could be reshaped should recession risks rise. 

U.K. Retail Sales (Thursday)

The U.K. economy had a streak of weak data in January that prompted market participants to revise sharply higher the odds of rate cuts by the Bank of England. These expectations moderated when they subsequently ran against stronger-than-expected post-election survey data and a hawkish Bank of England meeting. Next week’s retail sales data for January will be the first high-profile hard data on consumption. It will provide the first gauge on the extent to which sentiment improvements after the December election may have been backed by a resurgence in economic activity. Should the data surprise to the upside, the narrative on a post-election rebound would likely gain traction prompting markets to further trim odds of rate cuts by the Bank of England. Such repricing would weigh on U.K. gilts and support the pound. 

Australia Labor Market Data (Wednesday)

After rising in the first half of 2019, the unemployment rate in Australia has recently showed signs of improvement, possibly supported by the three rate cuts that the Reserve Bank of Australia delivered last year. The central bank has expressed great sensitivity to labor market dynamics at various times and it has recently reinforced this focus. Last week, Governor Lowe indicated at the House of Representatives that “if the unemployment rate were to be moving materially in the wrong direction” amid unchanged inflation, the RBA’s balance of arguments “would tilt toward a further easing of monetary policy.” 12 12 Close Speech by Governor Phillip Lowe, Canberra, February 7, 2020. Given the central bank’s focus on the labor market, next week’s release is significant to the outlook for monetary policy in Australia. A weaker-than-expected unemployment rate would likely prompt markets to price higher odds of RBA easing, including via quantitative easing, support government bonds, and weigh on the Australian dollar. 

 

 

 

 

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