Powell's Great War Tactics Catch Markets Off Guard

Points of Return

Powell's Cunning Plan

As the Federal Reserve's governors do battle with deflation, and with the markets, they are borrowing some tactics from the First World War. In the classic U.K. sitcom Blackadder Goes Forth, the British general briefs his officers on a "brilliant new tactical plan" — to climb out of their trenches and walk very slowly toward the enemy. To the objection that the British have tried doing this 18 times already, the response is that this will brilliantly allow them to catch the Germans off guard. "Doing precisely what we've done 18 times before is exactly the last thing they'll expect us to do this time."

This strategy never worked very well for the British in Flanders. But the Fed seems to have found an element of truth in it, to judge by reactions to the latest monetary policy announcement by the Federal Open Market Committee. The Fed did exactly what it said it would do. It also announced that it was going to carry on doing it for years. And yet somehow this took the market by surprise. The Fed did what everyone had expected, but that in turn had prompted many to bet that this would create the perfect conditions for a "dovish surprise" when they tried doing even more. When the Fed opted for another line of flat dots, and an unchanged plan for buying assets — the monetary equivalent of exiting the trenches and walking purposefully through No-Man's Land — the bond market responded as though it had instead sent in the hawks. Stocks had a bad day, while bond yields ticked up a bit and the dollar strengthened slightly.   

It is as well not to exaggerate the market reaction. No trends were displaced, and activity was quiet for an FOMC day. And the reason the Fed would probably stay within expectations was well understood in advance, and positive for the market: The economic data have generally been surprisingly good, and that makes even more extreme monetary aid hard to justify, particularly in the last meeting before a presidential election. The Citi Economic Surprise indexes continue to show U.S. data coming in far ahead of expectations, and to a much greater extent than the rest of the world:

The heavy lifting for this FOMC meeting had already been done with the announcement of a new inflation strategy (of "average inflation targeting") at the Jackson Hole symposium last month. The forecast for future interest rates shown by the "dot plot," in which each governor's prediction is marked by a dot, could scarcely be more dovish, predicting negligible rates flat-lining into the future:

There's no pleasing some people. What had the market been hoping for? The Fed could conceivably have announced even more asset purchases or, more likely started what is known as WAM — weighted average maturities, in which it manages maturing bonds to reinvest in longer-dated assets, and thus keep longer-dated yields lower for longer. Given how flat the 10-year yield has been, this shouldn't be a major issue for the markets.

Meanwhile, the targets set by Powell before rates will be allowed to rise look mightily optimistic. In the words of a couple of Bloomberg colleagues, they sound like "Morning in America" (Tom Keene) and "Nirvana" (Cameron Crise). According to Powell, rates will stay where they are until inflation gets back up to 2%, in combination with maximum employment, which according to the Fed's own estimates would be a rate of 4.1%. Neither of these levels sounds that remarkable, but there have been only three periods in the last 60 years when they have co-existed. They are marked on the following chart:

The horizontal lines mark 2% and 4.1%, and both unemployment and inflation need to fit between them for Powell's conditions to be satisfied. This version of economic "Nirvana" (in Cameron's phrase) happened for more than a year between 1966 and 1968 as the U.S. was struggling to finance war in Vietnam and inflation was steadily taking off. Other than that, nirvana was reached for a few months at the top of the internet bubble in 2000, and again very briefly in 2018 amid the excitement following President Trump's big corporate tax cut. 

So, Powell told us that rates will stay effectively at zero unless and until the economy reaches a state of near-perfection it has glimpsed only briefly and only three times in the lifetimes of most people now living. Traders will likely work out soon enough that it was greedy to hope that the Fed would be any more dovish than that.


China's Inflations

It's good to know that the great and the good are reading this, even if I only find out once I've made a mistake. In yesterday's piece on the trade relationship between China and the U.S., I made the point that the yuan-dollar exchange rate is back to where it was pegged during the worst of the financial crisis, and that as Chinese inflation had been much higher in the intervening period, this meant that China had lost competitiveness.

I should have been more careful as to exactly which kind of inflation I was talking about. Consumer prices have of course risen faster in China than in the U.S.. But Chinese producers have often had to deal with outright deflation. The following chart compares official numbers for changes in Chinese consumer and producer-price inflation:

With their prices falling for much of the time, Chinese manufacturers may have been rendered more competitive by a static exchange rate. Such were the arguments made independently on Twitter by Brad Setser of the Council on Foreign Relations, and by Michael Pettis of Peking University

Setser suggests that U.S import prices, largely for electronic goods, may be driven more by producer-price inflation and nominal exchange rates, and I fear he is right. He also offered this chart, which includes JPMorgan Chase & Co.'s calculations of the real effective exchange rates based both on CPI and PPI, as well as U.S. import prices:

Pettis points out that the differential between the appropriate U.S. and Chinese producer-price indexes "would actually suggest that the renminbi is more, not less, competitive than changes in the nominal exchange rate otherwise imply." He adds: "Of course China imports a lot of food from the U.S., so the CPI index isn't irrelevant, but the real change in the currency is probably more complicated than adjusting the nominal change by the CPI differential."

Again, I think he is right about this. My gratitude goes to both. The basic point stands, or is even amplified: The U.S.-China imbalance has deepened as a result of Covid-19. Naturally, it is difficult to avoid viewing everything through the lens of U.S. politics at present, but it behooves anyone with responsibility for investing money to pay close attention to this issue. It isn't going away.


Survival Tips

For the first time since the Ides of March, I have written this from the office. Bloomberg is monitoring employees closely, large swathes of the office (including the beloved snack bar) are off limits, and everyone needs to don a mask before leaving their desk. It is unnervingly quiet. The Bloomberg news room is huge, and structured much like a trading floor. Usually, on the afternoon of an FOMC meeting, it is hard to hear yourself think. There was no such problem today. 

Plenty of New York offices have already told their workers they will remain shut until next year. Schools are just embarking on a treacherous reopening. Some analogies with mountain-climbing, where the descent tends to be more hazardous than the ascent, may be in order. Getting the return right is difficult, and the temptation born of impatience to rush things must be resisted. 

With all those health warnings in place, it is still amazing how absence makes the heart grow fonder. After six months away, it is great to return to the camaraderie and structure of an office. Be careful about the assumption that the office is dead. We've learned about the possibilities of working from home since March, but also discovered plenty of limitations.

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