The Morning Commentary: Base Effects and Bottlenecks
A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.
Base Effects and Bottlenecks
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Andrew Kositkun Senior FX Advisor
The Federal Reserve met this past week and delivered a dovish hold with no changes to policy settings or forward guidance despite already very strong U.S. data and a much better outlook. During Fed Chair Jay Powell’s press conference, the key theme was one of “time.” The Fed is looking for time to work through transitory factors driving inflation higher and to fully heal the labor market.
The Fed can afford to be dovish, without concerns of eventually causing another taper tantrum, because the markets are already pricing in policy normalization. Survey data shows consensus expects quantitative easing (QE) tapering to start next year, while market pricing indicates the hiking cycle will start in 2023. This allows the Fed the luxury of taking its time to move to what the market is pricing or even slower without triggering a shock.
The Fed may also feel that the pandemic is not yet over and that substantial uncertainty remains. While developed market countries have improved progress on vaccinations, they are now reaching the parts of their respective populations that are more against vaccinations, slowing progress. In emerging markets, vaccinations are going much slower, which explains why COVID-19 infections are still rising. Further, new COVID-19 variants, for which existing vaccines may be less effective, remain a risk. It is still unclear whether or not COVID-19 vaccinations will be a yearly thing and whether some restrictions will have to remain in place for the foreseeable future. So while upcoming data is expected to deliver the critical mass of strong data the Fed is looking for, the timing of when clarity will be reached on COVID-19 risks is much less clear. The Fed could see such uncertainty as justifying a cautious normalization policy.
As a result, the U.S. should have an extremely loose macro policy stance, both historically and relative to the rest of the G-10. The Biden administration recently announced a proposal for an additional $2.8 trillion in fiscal spending on various social programs over the next 10 years, in addition to a $2.25 trillion infrastructure package over the next five years. Of course, all of this comes on top of nearly $3 trillion in spending in the past ~4 months.
While part of these plans will be funded by higher taxes on higher-income individuals and corporations, the net effect is still a major fiscal stimulus for this year and beyond. As such, the U.S. may be the only G-10 economy to close its output gap and be above pre-COVID-19 levels by next year. Should the Fed continue to maintain its policy stance against this backdrop, it would be the most historically loose stance by any measure we can think of.
Absent an unexpected development, G-10 foreign exchange markets should see limited volatility in the short term and before the Fed and the European Central Bank (ECB) move in opposite directions after the summer. By the August Jackson Hole meeting or the September FOMC meeting, the Fed is likely to have enough positive information to start talking about policy normalization. Conversely, the ECB’s Strategy Review should be coming out around the same time. This strategy review should explain how QE will continue after the PEPP ends in March.
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