UNITED STATES
The September FOMC meetings is the main event this week. It will be a turning point in several dimensions. First, we—and the entire market—expect the announcement of balance sheet reduction; the start of the process of unwinding the Fed’s $4.5trn holdings of Treasury and mortgage-backed (MBS) securities. The question is for when? Possibly, as soon as next month; most certainly, by early 2018. Second, it will be the last meeting of the Vice-Chair, Stanley Fischer. Fischer’s departure will leave the FOMC without one of its most astute and informed inflation watchers, and theoreticians. Moreover, and third, although this will not be Janet Yellen’s last meeting, it could be her last conference, pending the announcement of a new Fed head.
Because the FOMC took great pains to inform the market, including about the operational details, and because financial conditions have been loosening almost steadily since end-2015, there is absolutely no expectation of a “taper tantrum.” Nevertheless, the whole point of “normalization” is to redress in part the flatness of the yield curve. Strategists expect that the announcement will lift 10-year Treasury yields via the term premium and put modest downward pressure on equity valuations. The Fed will start with a cap on monthly runoff of $10bn that rises by $10bn every quarter until reaching $50bn in October 2018. Several estimates suggest that, at this pace, the process could end in 2021 with a terminal balance sheet size of roughly $3 trillion (13% vs. the current 25% of GDP).
- Wednesday, September 20: FOMC decision; new Fed forecasts, and Yellen press conference (Consensus: decision to announce start of balance sheet unwinding; no change in the reference rate). The process of balance-sheet runoff, though anticipated, is not, arguably, fully priced-in; for a simple reason. The Fed has carefully pre-announced the mechanics, and could give more details on Wednesday. It is trying to be as transparent as possible. Nevertheless, this is, in symmetry to the buildup, an unprecedented event. It is hard to know the impact. Meanwhile, for the market, the focus on Wednesday should be on changes to the dot plot and to the summary of economic projections, if any. As usual, it will be critical to follow Yellen’s Q&A for hints about the committee’s sentiment. On Sept. 5, overnight indexed swaps priced a 23% chance of hike in December. Now the odds of a December hike are about 40%. We believe it will happen.
- Thursday, September 21: Philadelphia Fed Survey – September (Consensus, 17 a drop of nearly 2pp). The headline index fell to 18.9 in August from a high of 43.3 in February. At that point, the index was at its’s highest level since January 1984. It should fall again this month. As we observed, post-election, sentiment indices were running ahead of actual data, notably for manufacturing. Many managers and survey respondents expected the new administration to adopt measures to favor profits and, in some views, not ours, growth. Policies such as protectionism and lower corporate taxes. Obviously, this did not happen. Measures of sentiment are trending down to pre-election levels. At 17, the Philly index—the most closely correlated with the ISM and actual manufacturing output—would be at its lowest since Nov/2016.
2Q Fed Flow of Funds. The Z1 tables of the Fed “includes data on the flow of funds and levels of financial assets and liabilities, by sector and financial instrument; full balance sheets, including net worth, for households and nonprofit organizations, nonfinancial corporate businesses, and nonfinancial noncorporate businesses.” They are the best indicator of household wealth and its distribution. As the Fed begins to unwind its balance sheet, there is little doubt that “unconventional monetary policy” increased household wealth, especially for those at the very top of the wealth distribution. The wealth effect was the main transmission mechanism for the conjoined tool of QE with forward guidance. It spurted consumption, business consolidation, and growth. Asset purchases, including MBS purchases, caused banks to lower lending standards and increase loan risk, reactivating the credit channel. For example, a recent estimate suggests that Fed MBS purchases had about the same effect on bank risk- taking as a one-percentage point decrease in the federal funds rate. Thus, unconventional monetary policy worked not only by increasing credit availability, but also by encouraging riskier lending. Flow of Funds Accounts for 2Q will likely reflect the rise in equity values and flat home prices in the period, leading to an increase of around $1trn in household net worth, following a gain of $2.3trn in the previous quarter. Lately, homeowners restarted to extract equity from their homes, reinforcing the boom in construction spending and consumption. The share of home-equity loans is still relatively low, nevertheless, compared to pre-crisis levels. This suggests that this channel of policy will continue pumping in the months ahead, even as the Fed begins to unwind the policies that first triggered the effect.
BRAZIL
On Thursday, the central bank publishes the Inflation Report (IR) for Q3. Likely, it will not add much to what we know about the probable path of the policy rate: A probable 50bp cut in October, to 7.50%, followed by a 25bp cut in December to 7.25%. There could be a final 25bp cut in January, but that would be it. Why? Because at that point, with year-ahead inflation expectations at 4-4.5%, the real ex-ante rate would be 3.25% or lower—and this is decidedly below the neutral real rate. No one knows where the neutral is. It is an unobserved variable, a construct of models estimated with great margins of uncertainty. Yet no one would guess it to be that low. That is where the IR could help. The central bank has already told us that, in its opinion, the nominal rate is already below the neutral, let alone when it is reduced further.
The point, however, is that the economy is well below its rate of potential growth, another construct of model estimates. Presently, the economy operates with a large output gap, which monetary policy stimulus will help close. And inflation expectations are firmly anchored. So, it’s OK for the nominal rate to be cut further. The question is, when will it start to climb back up. When will the central bank begin to take back the stimulus? This depends on its estimate of the neutral, which is why the market will give close attention to the discussion in the IR. It is generally easier to estimate the output gap than the neutral rate. The market has a good sense of where actual and potential GDP are—forecasts are plenty and quite accurate, at least for the medium-term trend. For example, there is near unanimity that the output gap will not close in 2018. What is more uncertain is how much below the neutral would a real rate at 3-3.25% be, say in late 2018, after the elections. We do not expect the COPOM to increase rates in 2018, barred major unexpected events. But to begin to guess when the next rate hike will be we will have to make a guess at the neutral—thus, read carefully the IR.
- Thursday, September 21: IPCA-15 (mid-month CPI inflation) – September (Consensus 0.13%mom). For the time being, disinflation is likely to continue. Last month’s IPCA-15 reading was 0.35% but the end-month August reading was lower. Helping the process is low food prices, and the absence of new shocks.
IMPORTANT NOTICES:
This report is a general discussion of certain economic and geopolitical trends and forecasts. It does not constitute investment advice of any kind or constitute a recommendation to buy or sell any security or other financial instrument. Investors may not rely upon any of the conclusions or other statements contained herein.
Certain of the factual information contained herein was obtained from third party sources which the author considers reliable, but the accuracy of such information cannot be guaranteed.
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