USA: updating financial conditions

In its central scenario, the Fed wants to raise the key rate to a neutral level of about 2.50%. An alternative, if inflation does not subside at all in the coming months, would be to set targets much higher and make policies restrictive. It is likely that the Fed will increase rate increases by 25-50 bp. at the next FOMC meetings in May and June, but its intentions have not yet been determined. This will depend in part on financial conditions (long rates, dollar, stock market). They have intensified since the beginning of the year, but this does not seem to have a significant impact on domestic demand.

US focus Bruno Cavalier, Chief Economist, and Fabien Bossi, Economist

2022.05.02.  Dollar index
Figure 1 United States: indices of the effective dollar exchange rate

The labor market is suffering from a shortage of available labor, and price pressures have continued to increase in recent months. One reason is that monetary policy is too accommodating. There is no need for the Fed to procrastinate: it must at least strive for neutrality (about 2.50%). Raising rates by 25 bp – This is too slow to reach this year. Jerome Powell has already telegraphed that next week’s growth will be 50 bp. The money market expects similar steps at the meetings in June and July. The FOMC remains divided over what to do after reaching this neutral level. It will depend on the direction of inflation. If the long-awaited decline in inflation has finally begun, the rate-raising cycle could be broken fairly quickly. Another parameter should influence the thinking of the Fed: the evolution of financial conditions. In order to calm the overheated economy, it is not enough to raise short rates, it is necessary, first of all, to tighten financing conditions and, as a result, encourage households and businesses to moderate demand. This includes rising long rates, strengthening the dollar, falling asset prices (stock market, real estate) or a combination of all of these.

2022.05.02.  Market volatility
Figure 2 USA: market volatility indices

When financial conditions tighten due to exogenous shock, the Fed may find it inappropriate and push its monetary policy in another direction. This happened at the end of 2018 (the rate increase stopped) and, even more sharply, in March 2020 at the beginning of the pandemic (rate reduction + QE). Nothing like that today. The exchange rate of the dollar rose sharply against major currencies (euro, yen), but in relation to a wider basket, including the currencies of Canada and Mexico, two key countries for trade with the United States, the rate is quite moderate (schedule 1). After a sharp correction, long bets tend to level off. Volatility shock shows signs of weakening (schedule 2). As for stocks, the decline in the S & P500 (-10% since the beginning of the year) is certainly not strong enough to worry the Fed. In general, there is no indication that the central bank believes that the financial conditions at this stage are quite tight.

Economy

According to a preliminary estimate by the BEA, real GDP contracted by 1.4% qoq in the first quarter of 2022 after growing by 6.9% in the fourth quarter. This is a result that at first glance does not coincide with what we know about the economic conditions of the last few months, which rather show overheating of the US economy. The labor market is hyper-tense, inflation is jumping, business climate indices are very high. The contradiction is only imaginary. The decline in real GDP is due solely to the negative contribution of foreign trade and inventories by -3.2 and -0.8 percentage points. in accordance. These articles “amputated” GDP growth precisely because domestic demand was stable and could be met only through import growth (+ 17.7%). At the same time, exports fell. The trade deficit in goods set a new record in March – $ 125 billion against $ 100 billion three months earlier.

Components of demand give a completely different picture of the US economy in the first quarter. Household consumption expenditures accelerated somewhat. in connection with the resumption of services, which more than compensates for the slight correction of goods. Investments in equipment for business jumped (+ 15.3%). Investment in housing continued to grow. Moreover, national accounts confirm strong price pressure. The GDP deflator, which provides the broadest measure of inflation, grew by 8% qoq in the first quarter, even more than consumer prices. In general, nominal GDP showed stable growth (+ 6.5%).

In February, the growth rate of house prices showed no signs of slowing down, on the contrary. The FHFA index reached + 19.4% in one year, the S&P / Case-Shiller index + 20.2%, both at new highs in this cycle. Some of these prices are set during the contract of sale and reflect the situation a few months ago, before the sharp rise in interest rates on loans. It is too early to say whether the tightening of borrowing conditions will affect demand and, consequently, prices.

In April, according to a Conference Board poll, household confidence remained almost unchanged, which seems to indicate a stabilization after a sharp drop in January-February. Employment conditions are declining somewhat, but remain close to their historical highs. Inflation expectations eased somewhat, from 7.9% to 7.5% in line with lower gasoline prices.

Monetary and fiscal policy

This week, FOMC members were in silence before FOMC meetings. The only information is the confirmation by the Senate by 52 votes to 43 Lael Brainard as vice chairman of the Fed.

Continuation of this week

FOMC meeting (May 4) is one of the highlights of next week. Given the latest declarations of central banks, the range of key rates will be increased by 50 bp. (instead of +25 bp in March), and a plan to reduce the balance by $ 95 billion. per month will be formalized (See Focus-USA on April 8). It remains to be seen whether this plan will be implemented immediately or with a delay of several months. The interest of the meeting is related to the signal that Mr. Powell will want to send to the markets by the end of the standardization cycle. In particular, is the FOMC already on the verge of another 50 bp increase? at the June meeting? Is a central neutrality scenario considered appropriate to ease inflationary pressures?

Another event in the coming days is the BLS report on the labor market in April (6th). With an unemployment rate of 3.6%, the economy is approaching full employment, as it was before the pandemic. The difference is that the pressure on wages is now much higher. The latest Beige Book signaled the beginning of moderation, but only in certain regions and not throughout. Labor shortages leave the market under pressure. New unemployment claims are below the 200,000 mark, unheard of since the late 1960s (for a much larger active population). This is normal when the pace of job creation slows down. As of the 4th quarter of 2021, it amounted to 637 thousand per month; in the 1st quarter of 2022 532 thousand per month. About 400,000 are expected. The Fed believes that the labor market needs to slow down.

Also follow the ISM surveys (2 for manufacturers, 4 for services). Preliminary data do not predict much change. Indices remain high, closer to 60 points (overheating) than 50 points (recession).