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How much more tightening can the US Fed still do?

Every summer, the US Federal Reserve (Fed) organizes a coveted economic policy symposium in Jackson Hole, Wyoming.

Posted on : Sat, 10 Sept 2022

Every summer, the US Federal Reserve (Fed) organizes a coveted economic policy symposium in Jackson Hole, Wyoming. The event is one of the longest-standing central banking conferences in the world, bringing together top economists, bankers, market participants, academics and policy makers to discuss long-term macro issues.

While the Jackson Hole Symposium always looms large in the economic agenda of investors and policy makers alike, this year the importance of the event was paramount. For the first time in decades, Jackson Hole took place during a historical policy normalization process amid well above target inflation.  

Importantly, however, the symposium followed a period of speculation about a potential near-term “policy pivot” from the Fed. After months of aggressive monetary tightening with successive rate hikes of 75 basis points (bps) each, investors were expecting that policymakers would be less aggressive after summer. The view was that US inflation likely peaked in June and “peak inflation” would beget “peak tightening.” In fact, markets even started to price significant rate cuts in late 2023.

Despite such hopes of a more moderate Fed, the tone from policymakers in Jackson Hole was decisively “hawkish,” i.e., biased towards a more aggressive tightening rather than a “dovish” policy pivot that supports more rate hikes and liquidity withdrawal. According to Fed Chairman Jerome Powell, progress on inflation “falls far short of what the Committee will need to see before we are confident that inflation is moving down” and “restoring price stability will likely require maintaining a restrictive policy stance for some time.” Moreover, Powell stressed that future decisions about rate hikes will be data dependent and another extraordinary hike of 75 bps “could be appropriate.”

In our view, the Fed will lean “hawkish,” raising rates by 75 bps in September and 50 bps both in November and December, before a final 25 bps hike in early 2023. It should then pause for a terminal rate of 4.25-4.5%. Three main reasons sustain our view on policy rates.

First, even if inflation in the US moderates significantly, it would still be well above the 2% target. In the past, every time US inflation breached the 5% mark, the price spiral problem was not contained before policy rates were aggressively hiked to a level that was at least as high as peak inflation. We do not see policy rates surpassing the likely 9.1% “peak inflation” of June this year, but the terminal rate of 3.8% that the market is currently pricing looks excessively optimistic.

Second, despite the recent slowdown, the US economy remains robust, which allows for more aggressive monetary policy tightening. The US consumer is particularly healthy, with households presenting a strong balance sheet with high levels of cash available (USD 15.8 trillion). This is supporting strong household expenditures in services, high levels of private domestic investments and a tight labour market. Such conditions are likely to make the Fed even more cautious in eventually pausing its rate hikes.  

Third, the current balance of institutional incentives favours the Fed to be more aggressive, even if higher rates could cause a more significant economic slowdown or financial dislocations. The credibility of the Fed is tarnished by its inability to recognize the magnitude of the existing inflation shock earlier last year. Hence, the Fed is still playing catch up with inflation and in a journey to reinstate its price stability credentials. In other words, the bar for a policy pivot is much higher now than it was in any of the monetary policy cycles of the last 40 years. The Fed is unlikely to pause before inflation rates are substantially lower for some time.

All in all, Fed officials took the Jackson Hole stage to re-set market expectations about rate hikes. The Fed is likely to continue to lean “hawkish” over the near term, as it will fight to reinstate its credibility in a context where inflation is set to continue well above target for some time while the fundamentals of the US economy will remain relatively strong.

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Europe’s dependence on Russian gas has been increasing for the past few decades despite massive investment in renewable energy. Indeed, the

Posted on : Sat, 20 Aug 2022

Europe’s dependence on Russian gas has been increasing for the past few decades despite massive investment in renewable energy. Indeed, the proportion of Europe’s gas coming from Russia rose from 26% in 2001 to 37% in 2019. Now, with the war in Ukraine, Russia is using this dependency to try and undermine Europe’s support for Ukraine and push for an easing of sanctions.

The dependence on Russian gas has means that prices have risen to record highs across the whole continent. Indeed, the Title Transfer Facility (TTF) benchmark gas price in Europe has risen to almost 8 times its average since 2010 (Chart 1). However, the pain is not being felt equally across the continent, with the countries in Northern, Central and Eastern Europe typically most dependent on Russian gas (Map).

Gas plays an important role in the European economy for heating homes, for heavy industry and as the marginal fuel in electricity production. Hence, these record high prices are already acting as a headwind for the European economy. But, with no end in sight for the war in Ukraine, financial markets have moved to price in persistently high gas prices into 2023 and 2024. This week, we consider the implications of this for Europe’s economic outlook, focusing on four main channels: the impact on consumer demand, industrial production, monetary policy and fiscal policy.

First, consumer demand is already being hit by high energy prices, capacity constraints and tight labour markets. Consumer confidence has deteriorated sharply, falling further since May as utility bills are now expected to double in many countries. Similarly, prices for holidays, restaurants and other services have risen sharply due to capacity constraints at airports and hotels, which have been unable to recruit sufficient staff, despite significant wage increases. In addition, goods prices remain elevated as global supply chain bottlenecks are easing only slowly. All-in-all, high prices for energy, services and goods are a major headwind for consumer demand across Europe despite the high levels of savings held by some wealthier households.

Second, record high gas prices have already caused large corporate gas users to reduce their consumption by a little more than 10%. Going further, in response to Russia reducing gas flows, the European Union has negotiated a target of a 15% reduction in gas use overall for 2022. But, if Russia cuts off gas completely, this may not be enough. Goldman Sachs estimate that a halt of Russian gas flows through the Nord Stream pipeline would reduce GDP by 3.5% in the Euro area, 3.7% in Germany, 5.6% in Italy, and 1.5% in France. Given, that flows have already been reduced to only 20% of capacity, then we can conclude that there will already be a sizable hit to GDP via lower industrial production in Europe.

Third, we consider the impact on monetary policy. Both the European Central Bank (ECB) and Bank of England (BoE) are lagging behind the aggressive series of interest rate hikes being implemented by the US Federal Reserve (Fed). This is already putting downward pressure on the EUR and GBP, which have depreciated relative to the USD. Weaker currencies are adding to inflationary pressures, on top of the fact that European inflation is more sensitive to energy prices, which are also higher in Europe than the US. It is therefore going to be very difficult for either the ECB or BoE to avoid hiking interest rates substantially despite the very real prospect of a sharp slowdown in GDP growth.

Finally, fiscal policy cannot come to the rescue for two reasons. First, compared to pre-pandemic governments are running with higher deficits and debt levels, which limits fiscal space. Second, governments cannot provide widespread support to all firms and households without driving both energy demand and inflation higher. Therefore, fiscal support must be limited and targeted, with direct payments to the most vulnerable firms and households.

In conclusion, weakening consumer demand, constrained industrial production, tighter monetary policy and limited fiscal support mean that European economies face several severe headwinds. These headwinds are all caused, or exacerbated, by high energy prices and/or limited gas imports from Russia due to the war in Ukraine. It seems increasingly likely that the war will drag on into 2023, which means that a recession in Europe is now looking more likely than not and that inflation is likely to remain persistently high into next year.

Download the PDF version of this weekly commentary in English or  عربي

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