HIGHLIGHTS OF THE WEEK
- Global bond yields moved higher this week following cautiously hawkish statements by central bankers last week.
- Above-trend economic growth in advanced economies is expected to persist. But, inflation is expected to lag owing to a number of structural factors working to suppress price growth.
- Altogether, model simulations of shocks to inflation and the unemployment rate supports the FOMC’s cautious pace of monetary policy normalization. The last thing the Fed or other global central banks would want to do is to have to reverse course several quarters from now, and risk impairing their credibility.
Fed is Right to be Concerned with Low Inflation
Although a short week, the bond sell-off resumed on global financial markets, taking yields higher following cautiously hawkish statements by central bankers last week (Chart 1). Selling pressures intensified domestically and across the pond, with European markets reacting in advance of the tapering of ECB asset purchases expected to begin early next year.
Curiously, this repricing episode has little to do with a material change in underlying economic fundamentals. Indeed, economic growth in advanced economies has exceeded trend for a number of quarters and is expected to continue to do so through next year. Similarly, labor markets continue to tighten. This morning’s payrolls report shows that U.S. labor demand remains very healthy. The economy added 222k jobs in June – well above the estimated 80-100k jobs necessary to hold the unemployment rate constant. Furthermore, wage growth is encouraging, but still historically subdued given estimated tightness of the labor market.
Instead, markets had been caught overly discounting future inflation and rate guidance by central banks, and for good reason. Subdued inflation is a key concern of global policymakers, including the Fed, as the minutes of June’s FOMC minutes revealed this week. Participants are clearly concerned about the persistence of weak underlying inflation, even while they deemed risks to the near-term inflation outlook as broadly balanced.
Unlike in the past, monetary tightening this time around is likely to be more a leap of faith. Economists and monetary policymakers alike continue to believe that the relationship between economic slack and prices will eventually reassert itself, leading to sufficient price pressures to overcome some of the structural issues that are suppressing prices. Indeed, there is evidence that permanently weaker energy prices, changes in global supply chains, the expansion of the world’s effective labor force, and the persistence of global excess capacity are factors partly responsible for weakness in underlying inflation in the U.S. and abroad.
Worryingly, these structural factors are not expected to recede anytime soon. As such, the question remains of how inflation-targeting central banks plan to respond to a world of rising demand but weak inflation. Historically, this combination has signaled a positive global supply shock, requiring a more accommodative stance of monetary policy, the exact opposite of what has been communicated by some central banks recently. This is because low interest rates are less stimulative to the real economy if price growth is more subdued.
Model simulations utilizing the Fed’s FRB/US model highlights the need for a more accommodative monetary policy stance (Chart 2). The persistence of a -0.5 ppt shock to underlying inflation in the U.S. implies that the fed funds rate should fall by up to 60 bps a year from now. In stark contrast, further labor market tightening, in which the unemployment rate persists 50 bps below the natural rate, would imply an immediate 50 bps increase in the fed funds rate. Altogether, this simulation justifies the FOMC’s cautious pace of monetary policy normalization. The last thing the Fed or other global central banks would want to do is to have to reverse course several quarters from now and risk impairing their credibility.
Fotios Raptis, Senior Economist
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