These were dovish Fed minutes with the emphasis on sluggish inflation supporting our view that the central bank is in no rush to hikerates. Of course, the minutes paid homage to the low-rates-environment related capital misallocation risk too, but hiking rates preemptively to avoid capital misallocation seems far-fetched and could even turn out to be counterproductive. In this respect our own view is less reflected by the proponents of the misallocation argument notably by Williams and Dudley leaning more in the direction of Brainard and Bullard seeing the US economy settling into a persistent state of low productivity growth and low interest rates that calls for the central bank to keep its key policy rate flat over the next two and a half years.
A quick scenario analysis may help to define the most likely monetary policy path of the Fed. High debt and overcapacity is a global observation, but this finding applies to the US too. Investment returns have fallen globally and often have declined below the cost of capital. An early rate hike would push the cost of capital higher which, at constant rates of investment returns, will increase the pace of deleveraging causing first the economy to fall back and second the supply of capital to increase. The supply demand capital ratio will shift towards supply, suggesting bond yields to fall and the US yield curve to flatten and then inverting. Falling inflation expectations and falling US bond yields being the consequence of this policy would not reduce the prospect of capital misallocation, it may even increase misallocation pressures over the medium-and long-term.
A late central bank policy response following the path of inflation can avoid this outcome. In this case, higher rates would not lead to flattening of the yield curve. Rates following inflation keeps real rates low and hence will not increase balance sheet adjustment pressures. Ironically, the Fed staying lower for longer may reduce misallocation pressures relative to the early rate hike scenario. The minutes’ increased inflation emphasis seems to reflect this view.
There are FX conclusions to draw. First, the USD will remain offered for now with EM inflows slowly converting from fixed income towards equity driven. Secondly, an increase in global inflation expectations or an autonomous risk shock (Middle East, China’s capital flows, election surprises) are required to turn the USD back into the bullish camp. Given the divergence of global output gaps inflation in some DM economies where there is little of an output gap left should lead the inflation rebound. The US belongs in this camp. Hence, the performance of the USD should lean even closer to the evolution of US inflation expectations. Overnight the 5y/5y inflation swap has eased back to 1.9050% now at risk of breaking below the early August 1.8870 low. USD weakness is warranted.
In the UK, today’s focus will be on th release of July retail sales. With initial post Brexit soft data releases showing some weakness but not falling off the cliff as much as survey data suggest, there are views out there that the UK may avoid recession. Yesterday’s release of the July labour market report falls into this category. Here there are two points to make. First, the labour market is a lagging indicator. It stands near the end of the ‘food chain’. Unofficial data from the Recruitment and Employment Confederation, said the labour market was in “free fall” and that permanent hiring had dropped to the lowest levels since the 2009 recession. Weak Q2 productivity suggests that the labour market has little cushion with labour productivity poor and declining. Secondly, it will take timefor supply weakness to filter through into the demand side. Today’s July retail sales report may even come in strong, but it would make us sell GBP into strength. Given the UK’s wide 7% GDP current account deficit the UK cannot have demand outstripping supply growth for very long.