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What If r* (neutral rate) is much higher than expected?
8 March 2023, 3PM (UTC)
- Historically, FED’s tightening campaigns have always broken something
- 450bps of hike in the past 11 months, 500 Bln of balance sheet reduction = red hot job market + still resilient US Animal Spirits + sticky inflation + Loosening of the Financial Conditions + No credit event. To put into perspective: the 1994 normalisation, 300bps in 11 months as well and no balance sheet reduction, led to the Orange County bankruptcy and the Mexico Tequila crisis
- Why?
=> The response to the Covid shock = monetary AND fiscal stimulus
=> If the post-GFC has been characterised by the private balance sheet’s recession, post-Covid is all about a private balance sheet expansion = buffer
=> The DM Central Banks balance sheet = absorbing marked to market losses that would have hurt the private balance sheets otherwise
=> US Households Net Worth: still 35 trillions us$ higher compared to Q1 2020
=> DM governments still providing fiscal support as a consequence of the post-Russian invasion’s Energy Crisis = going against the DM Central Banks attempt to generate demand destruction
=> The world is changing and changing fast: deflationary forces that were in full motion over the past decades have been meaningfully altered. The new state of affairs: de-globalisation, national economism, protectionism, supply/demand imbalances, reduced pool of resources (workforce and commodities)
- Therefore:
=> WHAT IF the inexorable fall of r*, byproduct of a sluggish post-GFC recovery (consequence of the private balance sheet recession / acute deleveraging) and powerful deflationary tailwinds, is over??
=> WHAT IF the above mentioned structural US job market imbalances (highlighted again by Powell last week) means persistently elevated wages and very stubborn services sector inflation?
=> WHAT IF societal trends, deglobalisation, renewed unionisation, acute shortage of resources (workforce and commodities), populism are turning against a comeback into the “Goldilocks” regime of pre-Covid?
=> WHAT IF the FED is unintentionally under-estimating r*??
- One certainty:
* IF r is higher than what US policymakers want to believe, the current monetary policy is not as tight as thought. And that could explain why the only parts of the US economy that seem to be responding to the FED’s tightening campaign are those directly impacted by them. Starting with the housing market. This could also explain why the economy seems responding quickly to any temporary loosening of the Financial Conditions
* Everyone is desperately waiting for the impact of the brisk 2022 tightening to show up across the economy. Triggering a loss of growth momentum enabling the FED to finally pause. Why? Because this is always what happened in the past!! BUT again: if r is higher than the FED and markets think, you might be waiting for much longer and until the FED acknowledges the new state of affairs
* If r is higher than assumed, the curve inversion is not flagging a looming recession or an upcoming inflation normalization but instead the fact that the FED has much more to do…..and that the long run DOT has to be repriced to match a potential regime change where policymakers will have to deal with an inflation of the third kind. Not the cyclical, transitory, supply driven inflation that will abate over time. Not the cyclical demand driven that can be addressed by a very restrictive monetary policy (demand destruction). But rather an unpleasant mix of supply and demand driven inflation, byproduct of persistently unstable geopolitics, weaponization of commodities and supply chains, de-globalization, a shift to national security, protectionism and what we described as the death of d’Artagnan: from “One for all, all for one” to “I, Me and Myself”