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Uncertainty, inflation and a hint of higher rates

| December 13, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The consensus on the economy anticipates a calm and uneventful year ahead, but a few things could bounce growth and inflation in unexpected directions. Election uncertainty stands to replace trade as a temporary but clear drag on growth in the second half of 2020. Inflation should surprise to the high side as core PCE converges toward the higher levels signaled by both core CPI and the Dallas Fed trimmed mean PCE. And the Fed stands to signal late in 2020 that its next move is a hike as it reverses some of this year’s insurance cuts.

Election uncertainty replaces trade uncertainty

In 2019, one of the key developments was the buildup of uncertainty regarding the outlook for trade policy after U.S.-China negotiations broke down in May.  On-again, off-again tariff threats and a lack of clarity over how the trade talks would end up leading many businesses to pull back on their investment plans in the second half of the year.

My presumption is that the U.S. and China will complete a Phase One trade deal in the next few weeks.  This should lead to a period in the first half of 2020 when business investment can perk up, bolstered by greater (though not complete) certainty with regard to trade policy.  As a result, I see a risk that real GDP growth picks up in the first of half of next year, as the indomitable consumer is joined, at least for a time, by a healthy rebound in capital spending (a pattern that will also be bolstered early next year if/when the Boeing 737 MAX is recertified and production and deliveries of the plane resume).

However, at some point next year, possibly late in the spring or in the summer, attention will turn squarely to the 2020 presidential campaign.  When that happens, I suspect that business investment will once again recede, as firms wait to see how the election turns out and what sort of tax and regulatory policies are likely to prevail over the next few years.  It is too soon to say when the peak degree of uncertainty will hit – it could be late in the primary season, with the struggle between more moderate Democrats and progressives captivating (and potentially scaring) investors, or it could come in the last days leading up to the general election in early November.

As a result, while my economic growth forecast for the year is somewhat higher than consensus, I would put more emphasis on the hypothesis that the quarter-to-quarter growth pattern will be far rockier than the current projections suggest.  My best guess is that growth in the first half of the year could be noticeably better than the second half of 2019.  However, the third quarter of next year shapes up to be sub-par, while the fourth quarter seems like a particular wild card, as the outcome of the election could lead to a significant risk-on trade or a relief rally in risk assets and could lead to a boost or a sharp hit to the near-term economic outlook.

Upside risk to inflation

Roughly a year ago, both the headline and the core PCE deflator had made it to 2%, in the latter case for the first time in over six years.  However, oil prices plunged over the turn of the year, pushing headline inflation below 1½% by spring 2019, while the core PCE deflator posted a string of well below-trend readings early in 2019, dropping the year-over-year advance to the 1.5%-1.6% vicinity, where it has remained for most of the year.

The moderation in inflation this year has brought back the widely-held hypothesis in financial markets that inflation is mired below 2% on a trend basis and that there is virtually nothing the Fed can do to change that.  Thus, long-term inflation expectations have declined noticeably.  A measure of 5-year forward 5-year inflation TIPS breakevens spent most of 2018 well above 2% (this TIPS-derived measure is geared to the CPI) but has resided between 1.7% and 2% for much of 2019 (see Exhibit 1).

Exhibit 1: 5-Year forward 5-Year inflation expectations

Source: Bloomberg

However, the stage is set for a firmer inflation performance for several reasons:

  • Simple arithmetic. Headline inflation was essentially flat for three months (November 2018 through January 2019) because energy prices plunged.  As those readings drop out of the 12-month window, headline inflation on a year-over-year basis will leap unless energy prices fall again, but they have been rising on a seasonally adjusted basis recently.  Similarly, when the three soft core PCE deflator readings from January through March 2019 fall out of the 12-month window, unless we have a repeat performance in 2020, the year-over-year core gauge is also going to accelerate sharply, likely to and possibly slightly above 2% by as soon as March.
  • Dispersion. The core PCE deflator has been the FOMC’s favored gauge of underlying inflation, so the fact that it has been running well below 2% encouraged the Fed to aggressively take out insurance this year, cutting rates by 75 BPs even as economic growth remained above trend and the unemployment rate fell to a 50-year low.  However, other measures of core inflation have been running considerably higher.  The core CPI hit a 10-year high of 2.4% in August and September, and the Dallas Fed trimmed mean PCE deflator has been within a tenth of 2% on a 12-month basis for almost two years running.  Typically, when one gauge out of several is an outlier, it is the outlier that converges to the rest of the bunch, not the other way around, so I would look for the core PCE deflator to firm in 2020, even if the underlying inflation reality does not shift much.
  • Fundamentals. While inflation has not been closely correlated with the economy or the labor market in recent years, to the extent that inflation is (or will be) driven by fundamentals, those signs all point to higher, not lower, inflation.  The economy has grown at a consistently above-trend pace (there has been only one sub-2% quarter for real growth since the spring of 2016), and the unemployment rate has fallen to a 50-year low.  On top of that, if anything, tariffs implemented over the past year are likely to add further to inflation pressure at the margin, even if some of the tariffs currently in place or threatened are cancelled as part of the Phase One deal.

Thus, while financial market participants have grown comfortable with a soft inflation outlook for 2020, I see a risk that price increases will pick up somewhat, probably hitting and possibly eclipsing the Fed’s 2% target.

The Next Fed Move Is a Hike

After being pushed around by market participants for most of 2019, the FOMC managed to successfully execute a “cut, then pause” maneuver in October.  Although there was a degree of skepticism in the days immediately after the October FOMC meeting, market participants fell into line fairly quickly with the notion that the Fed had moved to the sideline after its third rate cut of the year.  Since the October meeting, the economic data have been mixed but broadly supportive of the view that the Fed does not need to add further stimulus.  Thus, fed funds futures only have one rate cut priced in for all of 2020 and are pricing low odds of that move taking place early in the year.

I do not disagree with the prevailing view that 2020 could be relatively quiet on the monetary policy front, but I believe that the markets have the direction wrong.  In my view, the next Fed move will be a rate hike, though I do not expect to see such a move until after the election, i.e. no sooner than very late in 2020.

The main reason that I expect the Fed to raise rates when it next moves is that, as laid out in the prior section, I look for inflation to accelerate next year, likely to just above the Fed’s 2% target, while economic growth remains at or above the Fed’s assessment of the longer-run trend.  Chairman Powell suggested at his post-FOMC press conference in October that the Fed would probably want to see a pickup in price hikes before considering a rate increase.  This is a key reason why market participants continue to price in a downside bias to the policy outlook.  However, with monetary policy clearly accommodative and with President Trump likely to lay off on the tariff threats in 2020 in hopes of promoting strong U.S. growth in advance of the election, I do not expect the conditions for further easing to materialize.

Indeed, the election will likely play a role in the Fed’s thinking next year.  Given President Trump’s anti-Fed bluster, the FOMC is unlikely to raise rates during the election season unless the case is compelling.  In a normal political environment, I would probably have penciled in a rate increase for around mid-2020, based on my projection that inflation will modestly exceed the Fed’s target by then.  However, I look for the Committee to lay low, especially in the summer and early fall, to attempt to stay out of the headlines during the campaign.  As a result, the Fed may find itself somewhat behind the curve by late 2020, needing to take back the insurance moves adopted this year beginning soon after the election.

The underlying consensus

These likely surprises stand in contrast to the placid view of the economy painted by the current consensus. The December Blue Chip Economic Survey calls for a 1.8% real growth next year, roughly in line with the FOMC’s assessment of the economy’s longer-run trend.  Moreover, the quarterly projections show minimal fluctuations: 1.8%, 1.8%, 1.7%, and 1.7%.  Meanwhile, consensus projections for inflation call for the CPI to increase by 2.1% next year, which would generally be consistent with a 1¾% rise in the PCE deflator, not far from where it ended 2018 and is likely to reach by December of this year.  Given this quiet economic outlook, fed funds futures indicate that market participants are pricing in one rate cut for all of 2020.  Thus, if the year plays out as expected, it is likely to be pretty boring.  My guess is that things will be considerably more interesting than that.

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