Through the looking glass
16 January 2018
In recent briefings we have set out a rather bullish central scenario for economy in 2018. That view is predicated on four main assumptions: 1) core inflation picks up, but only slowly, allowing the Federal Reserve (Fed) to continue withdrawing policy support gradually; 2) the neutral real interest rate is set to rise above zero as the scars from the financial crisis fade, leaving the stance of policy accommodative even as nominal rates rise (see Chart 2); 3) the president’s anti free-trade rhetoric remains just that, with protectionist measures remaining both small in scale and targeted; and 4) financial conditions remain benign, with term premia staying low and hence long-term interest rates staying within their multi-year ranges (see Chart 3), while the dollar does not meaningfully appreciate. This week we ask what would happen if most of these assumptions turn out to be wrong.
In this alternate universe, the first cracks in the bull case appear after the February CPI report is published on 13 March and the core CPI increases 0.3% in the month. By then there have been three consecutive upside surprises to core inflation and it is becoming apparent that last year’s weakness was an aberration. News articles about the ‘broken’ Phillips Curve give way to stories about its non-linearity as the unemployment rate is sitting below 4% and the Fed appears to be behind the curve. Thereafter, markets are dealt two additional blows. On 21 March the Fed lifts its policy rate as expected, but shocks the market by factoring in seven additional hikes to its median projections by end-2019, with Chairman Powell sounding concerned about an overheating economy. Then after months of difficult negotiations, President Trump gives notice of his intent to withdraw from NAFTA. Within two weeks markets have repriced for the new environment no longer doubting the Fed, bond investors have bid up the 2-year yield to 2.65%. Fears about the consequences of the president’s protectionist turn have put a rocket under term premia, sending the 10-year yield above 3%, with the 30-year mortgage rate sitting at a Z-year high. Against this backdrop the dollar quickly jumps 5%, volatility returns with a vengeance and equities drop 15%.
The fallout over the next six months is ugly. Unlike in early 2016, the strength of inflation initially dissuades the Fed from soothing market fears. By the fall, indicators suggest that growth is slowing sharply. Housing starts and homes sales begin declining in the face of higher borrowing costs. Despite the boost from tax cuts, consumer spending moderates as the shifting inflation and market environment leads households to lift saving. And the manufacturing PMI plunges below 50 in the face of the resurgent dollar and potential for supply chain disruption. Meanwhile, equity prices fall another 10% as analysts are forced to lower their earnings projections. It is not until mid-November when data show that the economy added just 25k jobs in October amid sharply rising jobless claims that the Fed changes course delivering a very dovish statement. Powell follows up, implying a long pause in rates and that any further stress will be met with a resumption of Treasury reinvestments. In response, bond markets rally, the dollar drops and equity prices quickly recover half of their losses. A likely scenario? No. Plausible? Yes – and a reminder to guard against complacency, even when the macro environment looks as good as it does now.