Jerome Powell faces a ‘poisoned’ scenario no central banker would envy
The new chairman of the Federal Reserve will need to take an aggressive stance to win back market confidence or risk accusations of being behind the curve
President Donald Trump may have done Janet Yellen a favour by not giving her a second term as chairwoman of the Federal Reserve. Her successor, Jerome Powell, may have inherited a poisoned chalice. The Fed will have to up the pace of US rate hikes or risk accusations of being behind the curve as markets react to signs of rising inflation.
At the start of February, there was an above-forecast 2.9 per cent year-on-year rise in US average hourly earnings (AHE) for January, the biggest increase since June 2009. Analysts noted however that as there had been a fall in the average number of hours worked in January that would have bumped up the AHE figure.
Then last week the headline month-on-month US consumer price index (CPI) for January was also above consensus. More importantly, the core US CPI, excluding volatile components such as food and energy, rose by 0.349 per cent compared to the previous month, significantly above the 0.2 per cent increase analysts had expected.
Again though, analysts could explain their CPI underestimates by noting that clothing prices unexpectedly jumped 1.7 per cent in January, the biggest monthly increase for apparel since 1990.
Yet Thursday’s release of US producer price index (PPI) data also provided a surprise. While the headline 0.4 per cent month-on-month rise in January matched analyst expectations, core PPI rose by 0.4 per cent month-on-month, double the 0.2 per cent that had been expected by analysts polled by Bloomberg.
Also on Thursday, the New York Fed’s Empire State Manufacturing prices-paid index rose by 12.4 points to 48.6 in February, a level last seen in 2012, while data from the Philadelphia Fed Manufacturing Business Outlook Survey saw its prices-paid index reach its highest level since 2011.
Proof may not yet be conclusive that US inflation is on the rise but since when did markets need proof?
Back in December the Federal Reserve was gearing up for three rate hikes in 2018. That’s now looking conservative. Jerome Powell’s Fed is expected to hike US interest rates next month but the US central bank may also have to acknowledge that the evolution of US inflation data will now require four rate hikes this year.
And this is against a backdrop of a fiscal need to increase issuance of US Treasuries following the US’ enactment of tax cutting legislation and the passing of a new federal budget.
Morgan Stanley argued on Friday that the imminence of increased US Treasury short-tenor issuance “has helped to flatten the US yield curve, providing another indication for USD weakness.”
Additionally the US bank contends that “funding the [US] fiscal deficits within the front end of the curve has the potential to create a wave of large issuing needs down the road at a time when the Fed reduces its Treasury holdings, not boding well for the US capital market outlook. Consequently, the USD’s risk premium will have to increase.”
Dutch bank ING is thinking along similar lines, writing on Thursday that “typically the term premium is seen as the extra risk premium longer term bond investors require to account for inflation and demand/supply imbalance” and concluding that a fiscal risk premium is beginning to be priced into the [US] dollar.
Indeed ING feels that “inflation expectations have only accounted for around 20 per cent of this year’s rise in [US] Treasury yields” and that “the rising term premium has been the biggest factor driving US yields higher in 2018.”
International investors, perhaps also wary of the commitment to a strong dollar policy of US Treasury Secretary Steven Mnuchin, have arguably already begun to react.
Data from the US Treasury last Thursday showed overseas holders sold US Treasuries in December for the third straight month in succession, surely partly in expectation of lower US bond prices and higher yields ahead. China may have increased its own holdings of Treasuries in December but Japan has been selling US assets for five months on the spin.
Japan’s selling and any accompanying conversion of US dollars to yen perhaps helps explain recent downward pressure on the dollar/yen exchange rate.
A reasonable desire from investors to be better compensated for financing the US government’s expanded borrowing requirements, combined with some concerns that US inflation pressures are anyway re-emerging, puts upward pressure on US yields.
This particular set of circumstances could also weigh on the US dollar, adding to fears of higher imported inflation, making investors even twitchier.
Jerome Powell’s Fed needs to get in front of this situation or be judged to be behind the curve.