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New phase of monetary policy easing starting; rate cuts won't have same impact as before

Jeffrey Tan
Jeffrey Tan • 12 min read
New phase of monetary policy easing starting; rate cuts won't have same impact as before
SINGAPORE (July 1): In December 2015, the US Federal Reserve raised interest rates for the first time in a long while. This ended the unprecedented era of ultra-accommodative monetary policies deemed necessary to resuscitate economies after the 2008/09 gl
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SINGAPORE (July 1): In December 2015, the US Federal Reserve raised interest rates for the first time in a long while. This ended the unprecedented era of ultra-accommodative monetary policies deemed necessary to resuscitate economies after the 2008/09 global financial crisis (GFC).

With nine hikes over the last four years, the fed fund rate has increased from between 0.0% and 0.25%, to between 2.25% and 2.5% currently. The US central bank was expected to further normalise interest rates to above 3%, but it has now paused the hike cycle and is poised to loosen monetary policy — again.

Following the conclusion of the Federal Open Market Committee meeting on June 18 and 19, the Fed announced that it had kept interest rates unchanged. This is the second time it has done so since the FOMC meeting in January. Fed chairman Jerome Powell recalled that the US central bank’s policy stance had been “broadly appropriate” since the beginning of 2019, and that it had been “patient” in making any changes.

In particular, the Fed highlighted that the US labour market remains “strong” and that economic activity is rising at a “moderate rate”. Job gains have also been “solid, on average, in recent months”, and the unemployment rate has remained low. Household spending also appears to have picked up from earlier in the year, it added.

However, the Fed noted that indicators of business fixed investment have been “soft”. It pointed out that overall inflation and inflation for items other than food and energy are running below 2% over the last 12 months. Moreover, market-based measures of inflation compensation have declined, while survey-based measures of longer-term inflation expectations are little changed.

Other forward indicators have also raised the alarm. The sharp slowdown in global manufacturing at the end of last year has continued over the last few months. World industrial production growth has fallen below 1.5% y-o-y, the lowest rate since late 2015/early 2016, according to Fitch -Ratings. Manufacturing Purchasing Managers’ Index (PMI) surveys in the eurozone have remained below 50 and have recently fallen sharply in the US and the UK, it says. China’s official measure also fell back below 50 in May after a short-lived recovery in March and April, it adds.

In addition, the US yield curve inverted briefly in March, and again recently. In particular, the spread between the three- and 10-year Treasury notes has now fallen below zero twice this year. A yield curve inversion generally lasting more than a month has preceded every one of the seven US recessions in the last 50 years, according to Vanguard. “The markets haven’t moved the three-month Treasury bill much in the first five months of 2019, whereas the yield on the 10-year Treasury note has sunk by roughly half a percentage point, which we would attribute largely to a general risk-off sentiment that has come over the markets in the last month and a half,” says Vanguard in a June commentary.

Ultimately, the Fed’s biggest concern is the trade war between the US and China. There are attempts to reach a deal, but it is also a question of when it will happen, if at all. “In the light of increased uncertainties and muted inflation pressures, we now emphasise that the committee will closely monitor the implications of incoming information for the economic outlook and will act [appropriately],” Powell said at a press briefing following the June FOMC meeting.

Market observers are predicting that the Fed will implement interest rate cuts in the second half of the year. The probability of three and four rate cuts has now risen to about 40% and 20%, respectively, according to Bloomberg. On the other hand, the probability of one rate cut or no change at all has fallen to near 0%. “Markets are betting on frontloaded rate cuts justified -either as ‘insurance cuts’, [a] shield against heightened trade tensions or to safeguard against a cyclical slowdown in US growth,” DBS Group Research economist Radhika Rao writes in a June 24 report.

David Gaud, Asia chief investment officer at Pictet Wealth Management, says he is expecting two rate cuts over the next 12 months. The first would likely be implemented at the end of the year — not earlier — because the macroeconomic situation is “not painful enough yet”. “What is really important is that they are monitoring the situation closely. Interest rates are going to remain low for a longer period of time,” he says at a recent media briefing.

John Bilton, global head of multi-asset strategy at JPMorgan Asset Management, says the shift in rate expectations has been “profound”. “[The] markets are now pricing in the fastest pace of rate cuts in more than 30 years, absenting the GFC. This is all the more notable given that just six months ago, the market was still pricing in rate hikes, and the Fed’s dovish reset coincided with a US 1Q GDP print that was the strongest in four years,” he says.

So is the US about to enter into a new phase of monetary easing? Is cutting interest rates really the best move going forward?

Pretty good shape

Some analysts such as Kenneth Taubes, chief investment officer at Amundi Pioneer Asset Management, are of the view that the US economy is still chugging along fine and there is little evidence of it slowing down. Consumption, which underpins two-thirds of the US economy, has continued to be robust and may even outperform. “So far, this quarter’s consumption looks better than 1Q’s, based on data I’ve seen,” he tells The Edge Singapore in a recent interview.

He notes that both US income and job growth are good, and the housing sector is doing well as housing applications have picked up. Moreover, automotive sales were higher in May compared with April. “The consumer is still in pretty good shape, frankly,” says Taubes. “They feel like they can spend money.”

While Taubes acknowledges that the manufacturing PMI has weakened, he says this could be due to a build-up in inventory. He believes some companies have deliberately overstocked inventory to beat the trade tariffs. “I think people have exaggerated some of the slowdown in industrial production. The Fed released industrial production numbers last month. It wasn’t bad.”

Taubes does not think cutting interest rates is the best way to support the economy. The way he sees it, the Fed might be better off embarking on a new round of bond buying to create liquidity. “The problem with cutting [interest] rates now is that financial assets haven’t really come down at all. They could continue to provide fuel for asset bubbles,” he says. “I would maybe suggest to them to re-evaluate what tool to use first.”

According to Taubes, liquidity in the banking system is “slowly but surely getting worse” as excess reserves in the system are drying up. This is compounded by the fact that the excess reserves are not evenly distributed, though they are still high by historical standards, he warns. Currently, most of the excess reserves are held by the large central banks. Hence, the smaller- and medium-sized banks need to scramble for deposits to fund loan growth, he explains.

No deal, no escalation

Still, if the Fed chooses to cut rates, it may be because the US central bank wants to take an “anticipatory” approach, says Taubes. This is to account for the risk of further trade tensions between the US and China. In June, US President Donald Trump warned that he might slap tariffs on the remaining US$300 billion ($406 billion) worth of Chinese imports. He also increased the tariff rate imposed on US$200 billion worth of Chinese imports to 25% from 10%.

If Trump follows through on his threat, the US economy is likely to see a downturn as consumption is the only growth component left supporting it. The investment component is missing as the capital expenditure cycle has not recovered, says Pictet’s Gaud. On the fiscal side, the US government has yet to introduce any significant measures to stimulate growth. So, “if consumption starts to falter, there won’t be growth,” Gaud adds.

For now, there is some optimism that an escalation in trade tensions could be delayed. Trump and his Chinese counterpart Xi Jinping have confirmed that they will meet on the sidelines of the G20 meeting in Osaka on June 28 and 29. CMC Markets analyst Margaret Yang observes that the likelihood of the two leaders striking a meaningful deal is low and the most likely outcome is a “no deal, no escalation but trade talk continues” situation.

In any case, Mohamed Faiz Nagutha thinks the Fed is likely to wait for more signs of economic distress before cutting interest rates. The Asean economist at the Bank of America Merrill Lynch says the Fed does not want to be seen as reacting to Trump’s open call for a looser monetary policy. “This may embolden the US administration to turn more protectionist. It is a moral hazard for the Fed. So we thought that the Fed would wait a bit more, which is why we think that by September, some of the survey measures in the US will start turning bad. And that is when they will cut [interest rates],” he tells The Edge Singapore in a recent interview.

Running out of ammunition

So how different will monetary policy easing be this time round? For one, the Fed will be doing so from a level where interest rates are not fully normalised, says Nagutha. The current level is far below the rate of above 4% during the GFC. This means it has limited downward room compared with before. “They have to be very careful with utilising that room.”

Derek Halpenny, head of research for global markets EMEA and international securities at MUFG Bank, agrees. “The key difference with this easing cycle is the closeness of the lower bound. There is greater reason for the Fed to try and act aggressively in the early stage of the easing cycle in order to diminish the risk of hitting the lower bound and requiring further monetary easing. This raises the prospect of a more aggressive cut of 50 basis points in July as the Fed tries to get ahead of the curve to ensure financial market conditions [do] not tighten,” he says.

Another key difference is that the other major central banks have little to no ammunition left to cut interest rates. The European Central Bank (ECB) and Bank of Japan (BOJ) have traditionally synchronised with the Fed in the previous rate cut cycles. “So when the global economy went into a big downturn in 2009, everyone was able to cut interest rates to zero very [quickly]. Everyone was able to unleash successive rounds of quantitative easing [and] targeted longer-term refinancing operations,” says Nagutha.

However, only the Fed has managed to unwind some of this in the last few years, and not the ECB and BOJ. “This time round, when the Fed rate-cut cycle begins, these guys will be completely out of ammunition. They will not be able to do any-thing. So there won’t be a big coordinated stimulus to the global economy that you got in the previous cycles,” he says.

Furthermore, the global economy is operating in a very different world today. There is a growing sense that capitalism has only served to entrench the rich, while preventing the rest from enjoying equal opportunities. A widening economic inequality could further complicate the pace and size of monetary policy easing.

As Taubes explains, the impact of monetary policy is based on the trickle-down theory. “Supposedly, if you boost asset prices, people who don’t own assets will spend more money or will have more money to invest, and eventually companies would be able to hire more people,” he says. How-ever, that has not really happened.

Instead, financial assets have been “turbocharged” and growth has failed to pick up in places such as Europe, Taubes says. “So what’s happened is that the rich have gotten richer [because they are the ones] who own stocks, bonds and properties, which have gone up,” he says. “I think extreme monetary policy [easing] for a long period of time tends to exacerbate economic inequality.”

Still, not everyone agrees with that view. Rob Carnell, head of research and chief economist at ING Bank NV Singapore Branch, says the causes of economic inequality are more complicated than merely low interest rates. He says stagnant real wages, globalisation, automation and population trends play a part too. “I would imagine that [the central banks] would largely refute suggestions that such political changes or inequality have anything to do with them.”

Ducking fiscal responsibilities

Other market observers believe fiscal measures are a better approach. While looser monetary conditions are generally stimulative, Neuberger Berman president and chief investment officer Joseph Amato wonders if lower interest rates will actually help boost sustainable economic activity at this point in the cycle. “More worrisome is that lower rates provide cover for governments to duck their fiscal responsibilities, allow for unproductive enterprises to remain afloat, disincentivise corporate investment and create powerful headwinds for the banking system (particularly in Europe),” he writes in a note dated June 24. This results in sluggish growth, stagnating productivity and low returns on equity, he adds.

To strengthen his point, Amato recalls that the US had recorded strong growth from 2017 to 2018 without any dovishness on the part of the central bank. This was helped by a corporate tax cut and less restrictive regulatory policies.

As such, the US now needs to find enough political consensus to deal with longer-term fiscal issues, he says. This includes social security and Medicare and immigration reform — not to mention getting the infrastructure programme up and running. Europe similarly needs consensus on regulatory reform and corporate taxation, and a new economic model that balances the needs of its stronger and weaker countries, he adds.

“Lower interest rates will not deliver these things, in our view. As we have been saying for some years, governments have to do their job,” Amato says. “We believe solving these issues will go a longer way toward building business confidence, which will spur investment and lead to sustained productivity growth.”

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