Deflation, Demand, And The Federal Reserve

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Posted: Jul 12, 2019 9:04 AM
Deflation, Demand, And The Federal Reserve

Source: AP Photo/Susan Walsh

Equity investors buy when the Fed is easy and sell when the Fed is tight as surely as Pavlov’s dogs salivated when they heard the dinner bell. The market got a bit ahead of itself with apocalyptic expectations about the economy and interest rates before last week’s better-than-forecast employment report. Expectations of a Fed rate cut have attenuated and stocks have fallen modestly during the past couple of sessions.

Market attention is now focused on the July 11 report on US consumer prices, which presumably will influence the Fed’s thinking. The Fed looks not just at month-to-month price data but also at longer-term inflation expectations, as embedded in the difference between the yields of inflation-protected Treasuries (TIPS) and ordinary Treasury notes and bonds. This measure of expected inflation (“breakeven” inflation, that is, the inflation rate at which TIPS break even with ordinary Treasuries) continues to weaken, despite a bounce in oil prices.

The Fed (very oddly in my view) thinks that 2% inflation is the right number, so a dip to the 1.6% range at a 10-year horizon worries the Fed. There’s good reason to believe, moreover, that the weakness of inflation expectations arises from overall economic weakness. In fact, the decline of inflation expectations that is NOT explained by the price of oil during the past year or so tracks a high-frequency measure of economic strength. That is the Citibank US economic surprise index, which gauges whether economic reports differ from market expectations to the upside or downside. During the year to date, economic reports have consistently disappointed. 

Time series analysis confirms that the economic surprise index is a robust predictor of inflation expectations. That is bad news: disinflation and the expectation of worse disinflation to come stems from economic weakness.

That’s why I think the Fed will cut at least a quarter of percentage point at its July 31 meeting.

There is a school of thought among Wall Street forecasters, represented by Goldman Sachs’ chief economist Jan Hatzius and the economists of ISI, which believes that growth will bounce back during the second half of 2019. In a July 8 note to clients, Hatzius wrote that “we continue to believe that much of this weakness reflects the ongoing inventory adjustment, which is likely to subtract 1.7 percentage points from Q2 GDP growth. We are now probably near the end of this process, as the level of inventory investment seems to have fallen to a below-trend pace and the economywide inventory/sales ratio appears to be peaking.”

I can’t find support for this benign view in the data. There is no trend in the most recent survey data we have, for example, the regional Federal Reserve bank surveys, or the National Association of Purchasing Managers’ widely-followed diffusion index.

There is, however, a clear weakness in orders.

Against this backdrop, I find persuasive the argument of Morgan Stanley strategists that profits will not match market expectations during the second half of the year, and equities will perform poorly.

For investors with a bit of patience, Chinese equities are likely to benefit from the eventual resolution of the trade-tech war. For reasons I explained yesterday in Asia Times, Washington’s case against Huawei is crumbling. US pressure has failed to dissuade America’s allies from engaging the Chinese telecommunications giant to build 5G broadband networks, and the negative effects of the trade and tech war are evident, including in the American tech sector. The hawks have shot their bolt to no avail, and President Trump’s political self-interest makes discretion with China the better part of valor.