On the inflation side, there is little news to report. After three consecutive strong data releases for core CPI in the third quarter, the fourth quarter brought only relatively soft outcomes. Core CPI retreated slightly on a year-over-year (YoY) basis, from 2.4% to 2.1%.
The Personal Consumption Expenditures (PCE) measure – the inflation gauge favoured by the US Federal Reserve – also fell back: from 1.76% YoY in August to 1.62% YoY in November. A-cyclical items (as per the San Francisco Fed’s classification methodology pulled it lower). The data suggests that cyclical pressures are continuing to drive inflation up, but this is offset by falls in a-cyclical components.
Source: Bloomberg; December 2019
After lowering policy rates in July and September, the Fed cut rates once again in October. However, policy was left unchanged in December. For the first two rate cuts, the central bank had emphasised that it viewed these as a ‘mid-cycle adjustment’ and ‘insurance cuts’ intended to protect the economy against any downside risks from the trade dispute with China.
Investors had reacted poorly, interpreting the comments as signifying a reluctance to embark on a full rate cutting cycle if needed. The Fed was therefore more careful in September and October. It stated rates could be cut further if evidence supporting a ‘material reassessment of the outlook’ emerged. It noted that on balance, the risks were still tilted to the downside. In December, leaving rates unchanged, the Fed referred to ‘global developments and muted inflation pressures’. This suggested rate cuts were still more likely than increases.
These adjustments to the Fed’s tone provided support for the economy and financial assets. The 75 basis points of rate cuts helped to hold down Treasury yields and mortgage rates, while continuing to back housing activity. A dovish Fed, better data and renewed optimism on a trade deal pushed the equity market to highs.
Early in 2020, we take stock of developments and reassess the key risks to growth over the next few months.
Even if no escalation occurs, it should be noted that tariffs act as a tax on US consumers (who import finished goods) and US producers (who import intermediate goods). Some economists are warning of a scenario where existing tariffs hurt both business profitability and consumer purchasing power. In turn, this would hit consumer confidence, business investment and hiring.
We note that import volumes have fallen dramatically for goods subjected to tariffs, while there is scant evidence of substitution by domestic producers. Clearly, retail sales data should be watched closely for evidence of a pullback by consumers. However, higher asset prices and strong employment gains could well provide a sufficient offset to tariffs.
Our China economist, Chi Lo, judges that the central bank’s ‘selective easing’ stance, and financial system reforms, have likely been successful. Production of consumer goods such as cars and cell phones is recovering. And credit growth and infrastructure investments are at levels that should permit GDP to grow at a 6.1% pace. A stabilisation of Chinese growth would, of course, reduce a key downside risk to global growth.
We caution, however, that the nomination of a left-wing Democrat could be self-defeating – UK voters roundly rejected Jeremy Corbyn in the most recent election. We believe the American voter could react similarly to a Warren or Barry Sanders presidency. In our mind, the more centrist Joe Biden is the candidate with the best chance of denying President Trump a second term. He would be the less disruptive Democratic candidate for financial markets.
Overall, we conclude that the headwinds to growth in 2020 have likely died down versus our assessment in the previous quarter. Correspondingly, we now forecast 2020 growth at around trend (i.e. around 2%).
This more constructive growth outlook, of course, means that we view the Fed as much less likely to cut rates further – although the risk on rates remains tilted to the downside. The Overnight Index Swap market is currently pricing around 25bp of cuts by October 2021. That seems broadly reasonable to us.
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