Commentary Directory

The Week Behind

There was a lot to unpack last week after the Fed concluded its September meeting with a new release, new projections, and a fresh press conference appearance by Jerome Powell. Still no movement in policy though. Markets shrugged it off as the inaction was mostly expected, and concerns in China overshadowed.

The standard release in September indicated tapering is on the way more clearly, with the following phrase appearing for the first time: "If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted." This addition replaced wording that suggested the FOMC was still assessing the status of the recovery in July, and now members have confirmed that "conditions" are acceptable for tapering. Another thing to take from this is that the Fed does not see COVID risks as threatening to the overall economic outlook. There was only one minor change in the September implementation note; the per-counterparty limit for overnight reverse repurchase agreement was raised from $80 bil to $160 bil. Some may see that as an ominous signal of a financial system flushed with too much cash, but the NY Fed insists it's essential for smooth monetary policy implementation. Using the reverse repo market to stabilize interest rates is not a new strategy and was used in 2013 in previous periods of normalization.

The biggest news came from the FOMC projections which saw some pretty large shifts from the June numbers. Here are the three most important changed:

• Fed members are a lot more bearish on growth in 2021 with the median GDP growth forecast for the full year down to 5.9% from 7.0%. Instead, the growth that was originally projected in Q3 and Q4 2021 was pushed off to the beginning of 2022. The median full year GDP growth projections for that year is up from 3.3% to 3.8%. Overall, this does confirm that the Fed sees the current disruption in activity to be a temporary factor with the recovery to resume sooner rather than later.
• With supply disruptions persisting, the Fed has no choice but to acknowledge inflation will run rampant in 2021. The median PCE inflation projection for 2021 is now 4.2%, well up from 3.4% in June. Despite elevated expectations this year, the Fed remains rooted in the thought that inflation will moderate substantially in 2022 and 2023. The median projection for both is at 2.2%, pretty much unchanged from the June numbers. There is a slight acknowledgment of upside risk in prices in the members' range for 2022. The bottom side estimate is up just 0.1% to 1.7% while the top side estimate is up 0.5% to 3.0%. There is at least one FOMC member that sees inflation as more than temporary.
• The Fed does not give a schedule on rate hikes, but it does hint at timing in its projections and dot plots. Since June 2020, the median projected Federal funds rate (FFR) for 2022 was set at the lower bound 0.1%. That has finally changed. With more FOMC members forecasting a rate hike in 2022, the September projection of the FFR was raised to 0.3%. More specifically, June projections had 5 members seeing 1 hike and 2 members seeing 2 hikes in 2022 while September projections have 6 members seeing 1 hike and 3 members seeing 2 hikes. With rate hikes likely to come sooner than previously expected, many believe that tapering will begin in the November meeting since that will need to begin first.

The projections also pointed to an increase in uncertainty surrounding the growth outlook. As downside risks emerge. Cue the Evergrande crisis. With the large Chinese property development firm seeing major cash flow issues, investors are sensing that the overleveraged firm could spark more trouble in China's financial system because of its size (over $300 billion in liabilities). Relief may come from a very hands-on Chinese government that can choose how it defuses the situation. However, Xi's government, which has previously indicated that "deleveraging" is one of "five major tasks" in 2021, may not choose a friendly route.

Many major financial institutions see the Evergrande crisis as a risk to Chinese growth through the end of the year. RBC Capital Markets sees any kind of outcome being a "meaning headwind to domestic growth" and by extension having "global implications." Wells Fargo voiced similar concerns suggesting a resulting slowdown in China could "have material impacts on global growth that could weigh on the United States." The bank should be publishing its monthly international outlook report, and it will be interesting to see whether it updates its China growth forecast. Danske Bank does see some volatility stemming from the situation as its middle case sees the Chinese intervening "really late" and that "financial markets and global economy will take a big hit before things turn around again." Commentary from CIBC suggests that the banks is now expecting slower growth from China following the events, admitting that Beijing is "clearly willing to risk some slowdown to the economy as a whole" to use this situation to help stamp out excess debt.

Indeed, that could be another issue for the Fed to consider going into the November meeting as the large Chinese economy reacts. The setback to growth would combine from weakness in Japanese and Indian growth to make a for a very weak 2021 end in the Asia Pacific region. And of course, many of those countries are at the heart of supply chain disruptions that are causing inflation. This is just one factor of many that go into monetary policy decisions. It would take a disastrous outcome to really put pressure on normalization by developed market central banks. Nevertheless, some think that disaster is a potential end to the Evergrande story.

Chart of the Week

Mentions of "inflation" and "transitory, temporary" in Jerome Powell's press conferences following the FOMC meetings have been low in the last two meetings. Is the Fed shying away from the "transitory inflation" narrative? Or do members assume it has already sent that message to the markets successfully?

The Week Ahead

Next week brings the close of September and the beginning of a new month of economic data. The PCE Price Index reports on Friday as the month of October opens, bringing into focus how supply chain disruptions have affected prices in August. Additionally, throughout the week, markets will be watching Beijing to monitor how the Evergrande debt crisis will play out. It could have implications for Chinese and global growth.