Jay Powell could make a policy error if his FOMC conclaves use the oil bull market as a reason to prematurely tighten monetary policy.
The dominant theme of 2018 has been a rise in the bellwether 10-year US Treasury note yield from 2.40 per cent to 3 per cent amid fears on Wall Street that a rise in wage inflation and Trump tax cuts will force the Federal Reserve into an aggressive monetary tightening. However, the Fed’s projection for the US economy and its preferred inflation measure (personal consumption expenditure, or PCE) will be undermined by the dramatic surge in Brent crude, which could well propel the PCE to 2.5 per cent by late summer. This is the reason I believe a June FOMC rate hike is almost certain.
It is ironic that the Russian-Saudi Opec oil output cut deal and geopolitical risks in the Middle East contributed to the surge in black gold, not necessarily above trend demand. Yet incoming Fed chairman Jay Powell could make a policy error if his FOMC conclaves use the crude oil bull market as a reason to prematurely tighten monetary policy. Yet the rise in inflation break even rates and global metal prices (30 per cent rise in aluminium after Rusal’s US sanctions hit!) definitely exhibit an uptick in inflation risk. The correlations between crude oil and inflation expectations are high at almost 0.5. The ‘prices paid’ components of the purchasing manager manufacturing indices are also creeping higher. Inflation is creeping into factories, thanks to inputs like commodities prices.
Core inflation will continue to accelerate this summer and autumn, a disaster for owners of bonds, property or other fixed return assets financed by leverage. Unlike 2016-17, inflation risk is no longer skewed to the downside and the world’s central bankers will be forced to rethink their post-Lehman money-printing spree.
The history of the Federal Reserve since the late-1990s has taught me that its modus operandi is to launch preemptive rate hike strikes against an uptick in consumer price pressures. So I expect even a modest rise in the PCE or the core CPI above targets will force the Powell Fed to accelerate its pace of rate hikes in 2018 and 2019. The rise in three month Libor (and thus borrowing costs for leveraged bond and real estate punters, let alone debt addicted governments and corporates) presages the rise in the Fed Funds rate. As inflation overshoots the Fed target levels, the FOMC statement will get more hawkish and the Fed Funds rate could easily rise 150 basis points from current levels before the Federal Reserve achieves a ‘neutral’ level. This autumn, the world will about the abandonment of the Bernanke/Yellen gradualist stance on monetary policy the hard way.
The inflation overshoots I expect from the data this autumn will not be transitory, even if a 2.5 per cent CPI is nothing like the inflation nightmare of the 1970s and early-1980s. It is important to remember that the US business cycle is at a late stage, with a 3.9 per cent unemployment rate, an epic tax cut, trade tensions with China, rising twin deficits, an oil shock and rising political risk in Washington. There is a time for greed and there is a time for fear. This is definitely the time for fear.
There is now also a non-trivial risk that a series of aggressive Fed rate hikes to combat an inflation overshoot will tip the US economy into a recession. From Paul Volcker in the late-1970s to Alan Greenspan in the early-1990s and Ben Bernanke in 2004-06, successive Fed chairmen have demonstrated that the Federal Reserve will tolerate even a recession to combat inflation. In 1992, Greenspan’s rate hikes even costed President George H.W. Bush, the victor of Desert Storm, a second term in the White House. This would have never happened in a Third World banana republic where the central bank governor does not enjoy political independence. The independence of the Powell Fed will be tested as soon as his aggressive rate hikes doom President Trump’s bid for reelection. That will be the point when Powell will become Jughead Jerome on the Presidential tweeter feed and the world financial markets will tank in horror. As American politics degenerates into a surreal reality TV show, a 2019 recession could set the stage for a Democratic victory in 2020.
The surge in oil prices after US withdrew from the Iran oil deal is bad news for inflation in emerging markets with large current account deficits and huge external debts. This has led to full-blown currency crises in Argentina and Turkey. Will financial history repeat itself in 2018? Don’t fight the Fed!
This article provided by NewsEdge.