“Whatever It Takes”

Is It The Draghi Moment For The World’s Most Powerful Institutions?

Published in

DataDrivenInvestor

8 min readJun 17, 2023

Endless narratives have inundated social media since the beginning of the year. Nonetheless, the one that stands out and is consistent with the existing Central Bank policy action is “Higher For Longer”.

Yes, folks, it was an action-packed week where major Central Banks worldwide announced their policy decisions, and we also got crucial economic data.

While the Fed opted for a “hawkish pause”, the ECB hiked rates by 25 bps, PBoC announced “panic” cuts, and the BoJ maintained a status quo.

Until now, we saw synchronized monetary policy tightening in the West; however, the paths are now divergent as inflation remains a bigger problem in Europe compared to the US.

In the East, PBoC cut rates, albeit by only 10 bps for the first time since August last year, and the BoJ continued with its YCC policy, thus supplementing global liquidity.

The theme of monetary tightening in the West v/s monetary easing in the East is here to stay for the rest of the year.

Let us dig deeper and comprehend what’s in the minds of policymakers!

FOMC Decision And The Dot Plot!

“Talking about a couple of years out for Rate Cuts”- Jerome Powell.

As expected, all the Fed members unanimously decided to “pause” or “skip” and hold the policy rates at the current levels.

The JayPo’s press conference and the surprises in the dot plot led the market participants to term the policy as a “hawkish pause”.

Contrary to market expectations, the dot plot threw some stunners.

While the markets now expect a 25 bps hike in July (70% probability as per the CME Watch Tool) and then a pause till December, the Fed expects to hike twice(25 bps each) before the end of the year.

Furthermore, the Fed is projecting a resilient economy and has revised the GDP growth higher from 0.4% projected in the March FOMC meet to 1%.

The two major surprises for me in the dot plot were:

Revision of core PCE higher to 3.9% from 3.6%.
Hiking the longer run FFR to 2.5–2.8% from 2.4–2.6%.

At a time when headline inflation is exhibiting early signs of moderation, the hike in the core PCE should come in as a nasty surprise from the markets.

This also leads to the conclusion that the Fed is worried about the resurgence of inflation as the labor market remains robust. As a result, the decline in headline inflation should be taken as a pinch of salt by the markets.

Secondly, some market participants argue that taking the longer-run Fed rates to 2.5% paves the room for resetting the longer-term inflation target to 2.5–3% from the current 2%. If this indeed happens, then it will be catastrophic for the credibility of the world’s largest central bank.

It has been the Volcker moment for JayPo, and it will be a terrible mistake to amend the long-term inflation target when the inflation expectations remain well anchored.

In its dot plot, the Fed revised the year-end unemployment rate levels to 4.1% from the earlier guidance of 4.5%.

“While the jobs-to-workers gap has declined, labor demand still substantially exceeds the supply of available workers.”- Jerome Powell.

While Powell clearly states that the labor market is witnessing softening, his favourite labor market metric has been way above the pre-pandemic levels indicating that a lot of work is still to be done to crack the labor market and bring down the wages to a level consistent with 2% inflation.

One of the highlights of the “hawkish pause” was the Fed’s focus on convincing markets that rates would remain higher for longer.

This is persistent with what the Fed needs to tighten the financial conditions (NFCI) and kill the positive wealth effect, which can lead to a spike in inflation.

Surprisingly, NFCI had become too loose and is now at levels when the Fed began the hiking cycle.

Two significant reasons for loose financial conditions have been buoyant stock markets and tighter credit spreads, as these markets remain complacent despite higher rates and a fall in earnings. (Though markets are anticipating a recovery in earnings later this year, baffling many)

Note that the bankruptcies and defaults have also started to rise, which might lead to widening spreads in H2.

Economic Data!

The most important data of the week was the CPI reading which came broadly in line with expectations at 4%. I had been writing for months that headline inflation will fall to 3.5%-4% by June; however, the arduous task for the Fed will be to bring it down to their desired levels of 2% as wages are still above 4%.

The number that Fed had been looking at in the past few months has been the custom-made Supercore CPI or Services Ex-Rent, which has cooled off considerably from the peak but is indicating signs of stickiness.

The salient feature of the Supercore has been the stubborn nature of “transportation”. When we dig deeper, we find a strange anomaly; the transportation index has been buoyant due to the imputed costs of motor vehicle leasing, raising concerns that higher rates are flaring up inflation’s sticky pockets.

Nevertheless, as rates peak, we might see some stagnation in the Supercore. Furthermore, one of the tailwinds for lower inflation has been the healing of the supply chains and the drastic fall in commodity prices in the last few months.

The CRB Industrials Index has now breached the 2022 October lows, a sign of faltering global growth.

The Jobless Claims data continues to accelerate, indicating that the softening of labor market continues, albeit slowly.

The real retail sales contracted by 1.9% and have been in negative territory for seven consecutive declines, the longest down streak since 2009.

The industrial production ex- motor vehicles contracted by 1.2%.

All the incoming data demostrates that a growth slowdown and gradual deterioration in the labor market is underway.

ECB And The Chinese Economic Stagnation!

ECB raised its key deposit rates to 4% from 3.75%, the highest since 2001.

Following her counterpart’s footsteps, Lagarde was super hawkish and concerned about the “high wages”. As a result, ECB revised its core inflation forecasts higher to 5.1% from 4.6%, and the growth forecasts lower to 0.9% for 2023 and 1.5% for 2024.

Markets are pricing in another hike in July by ECB and no rate cuts this year.

Conversely, China is facing deflation and a “major” economic crisis.

As China’s “grandiose” reopening failed to take off, the CCP and the PBoC are preparing to fire the stimulus bazookas to revive the animal spirits.

This week, Chinese banks cut deposit rates after they were “supposedly” ordered to do so by the ruling party to encourage consumers to splurge on consumption rather than hoarding money in their accounts.

As the week progressed, the surprises kept on pouring, and PBoC cut the 7-day reverse repo from 2% to 1.9% for the first time since August last year. On Thursday, it cut the medium-term lending facility (MLF) loan rates by 10 basis points to 2.65% from 2.75%, making loans more affordable as demand for credit wanes in the wake of the property market debacle.

As per Goldman Sachs, the housing market will drag the growth for the coming decade. The painful deleveraging that developers undergo will make it nearly impossible for the property sector to revive materially.

Furthermore, the Chinese economic problems are compounded by worsening demographics and the drastic increase in the youth unemployment rate, which has now surpassed 20% and is at record highs.

Thus, the government and the regulators are leading the charge to diversify the Chinese economy to a consumption-led from an investment-heavy economy.

I have written an elaborate piece on the Chinese LGFV problems, which will be out next Saturday. Friends, you will understand why China will be in economic stagnation for years, akin to Japan’s post-80s bubble.

Conclusion!

The Fed is being as hawkish as it can and is projecting a scenario of “higher for longer”. However, the credit markets and stonks remain complacent due to excess liquidity sloshing around.
The dot plot indicates a resilient economy as growth is revised upwards, UR downwards and core PCE upwards.
While headline inflation is on the path to 3–3.5%, the challenge remains to bring it down to 2% without significantly hurting the labor market and, thus, the economy.
ECB and BoE will continue with the hikes while the Fed pauses as inflation remains a bigger problem in Europe than in the US.
The Chinese economy is undoubtedly struggling, and fresh stimulus measures were announced to drive the stagnant consumption. Policymakers are panicking and doing “whatever it takes” to revive growth.