Monetary Policy & Inflation | Politics & Geopolitics | US
With all the furore over the fiscal stimulus and the Fed 13(3) facilities, it is easy to forget that, even without additional easing, monetary and fiscal policies will remain exceptionally supportive next year (Striking a Minor Discord? The Treasury Wants Its Money Back…, 20 November 2020). Fed ownership of Treasury coupons is the highest ever, and unsurprisingly financial conditions are the loosest ever (Chart 1).
The Fed has made it clear that normalization is not coming anytime soon. Chair Powell sees too much uncertainty around immunization to upgrade his economic outlook. This suggests the Fed’s $120bn monthly security purchases are likely to continue well into H2.
Similarly, even without new fiscal stimulus next year, fiscal policies in the US and globally will remain among the most stimulative on record. And, of course, should Congress pass the proposed $0.9tn stimulus, this would increase the 2021 deficit by a further 4% of GDP.
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Summary
- Risk assets have a banner year ahead of them for three reasons.
- First, even without additional easing, monetary and fiscal policies in the US and globally will remain exceptionally supportive.
- Second, inflation will remain low and central banks will remain on the sidelines.
- Third, markets will look through any economic weakening on the way to normalization.
- Key risks to the outlook are China, which will come under pressure domestically from its weak financial sector as well as globally for its treatment of Hong Kong and the Uighurs, as well as the euro area, where the old fault lines are already re-emerging.
Market Impact
- The SPX could have about 20% upside, and the laggards like Ems and value stocks could outperform.
- Bonds may not sell off much a split Congress will limit US supply, inflation is likely to disappoint, and the Fed’s enormous spring asset purchases will dampen any upward pressure on yields. 10yr yields at 1% by end-2021 seems reasonable to me.
2021 Policy to Remain Exceptionally Supportive
With all the furore over the fiscal stimulus and the Fed 13(3) facilities, it is easy to forget that, even without additional easing, monetary and fiscal policies will remain exceptionally supportive next year (Striking a Minor Discord? The Treasury Wants Its Money Back…, 20 November 2020). Fed ownership of Treasury coupons is the highest ever, and unsurprisingly financial conditions are the loosest ever (Chart 1).
The Fed has made it clear that normalization is not coming anytime soon. Chair Powell sees too much uncertainty around immunization to upgrade his economic outlook. This suggests the Fed’s $120bn monthly security purchases are likely to continue well into H2.
Similarly, even without new fiscal stimulus next year, fiscal policies in the US and globally will remain among the most stimulative on record. And, of course, should Congress pass the proposed $0.9tn stimulus, this would increase the 2021 deficit by a further 4% of GDP.
Core PCE Inflation to Remain Well Below 2%
Core inflation is likely to remain well below 2% in 2021 for two reasons. First core goods inflation has already turned negative MoM and is likely to remain so during 2021.
Second, services inflation is likely to remain tame next year. Over the longer run, core services inflation tends to reflect wage growth. And wages are unlikely to recover much next year because participation and the employment-to population-ratio remain well below pre-pandemic levels. As the economy normalizes, participation will rise. This will keep wage growth in check. In addition, the pandemic catalysed efficiency gains that will partly offset any increase in wages.
Lastly, while money growth has spiked, it seems more likely to translate into financial asset price inflation than goods and services inflation. This is because money has mainly accrued to economic agents with a high propensity to save, namely higher-income households and corporations (M2 Spike Unlikely to Fuel CPI Inflation, 29 October 2020).
Markets to Look Through an Intervening Slowdown
For all my optimism about 2021, the economy is clearly slowing down (August NFP Show Economy at a Crossroad, 4 September 2020). So far, the decrease in budget support has been offset by a normalization of the household savings rate, and consumption has continued to grow but at a slower rate. The extrapolation of this trend would see consumption and GDP contract in Q1. But markets, and many businesses, would likely look through it provided mass immunization and economic normalization are firmly underway and provided the downturn has no long-term consequences. This is my base case scenario.
Risks
The main risks to this rosy outlook, in my view, are with China and the euro area. For more than a decade China has gone through credit growth that in other countries has ended with a crisis, typically following a shock. So far, there are limited signs this is happening; but it is far too early to sound the all-clear.
In addition, as the pandemic recedes, China is likely to come under increasing global pressure over its treatment of Hong Kong and of the Uighur minority. This could impact both Chinese external trade and capital flows. The Biden administration has not signalled a softer China stance.
Paradoxically, the pandemic provided the euro area countries with a reprieve by allowing for fiscal easing. But once the sense of urgency starts to abate, the strains of a system running on perennial austerity are likely to re-emerge. Target2 balances have started widening again, and a close advisor of Italian Prime Minister Conte recently suggested that the ECB forgive the sovereign debt purchased to fight the pandemic. Needless to say, ECB officials shot the idea down. But with Italy further fragilized by the pandemic, the debate is only going to become louder.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)