Economy

Highlights Looking past the day-to-day noise of trade-related announcements, we view the underlying odds of an actual trade agreement this year to have fallen below 50%. For the purposes of investment strategy, China-exposed investors should now simply assume that the U.S. proceeds with 25% tariffs on all imports from China. Given this, investors should stop focusing strictly on the odds of trade war, and should instead start focusing on the likely net impact of the tariff shock and China’s inevitable policy response. Simulated and empirical estimates of the impact of a 25% increase in tariffs affecting all U.S.-China trade suggest that economic conditions in China are likely to deteriorate to 2015/2016-like levels. This implies that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. The preference of policymakers is to prevent another significant episode of releveraging, but the constraints facing policymakers suggest that one is unlikely to be avoided. We see a meaningful chance that this tension will be resolved by a classic market “riot” over the coming 3 months as financial markets force reluctant policymakers to capitulate. We would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately respond as needed. We recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. Feature U.S. and Chinese negotiators failed last week to secure an agreement deferring the threatened increase in the second round tariff rate.1 The tariffs increased on Thursday at midnight for goods not already in transit to the U.S. (effectively doubling the existing tariffs), which was followed by the inevitable retaliation by China on Monday (scheduled to take effect on June 1). The retaliation, coupled with President Trump’s earlier warning that China should not do so, was taken by investors as a sign that 25% tariffs on all goods imported from China will soon be in place. As we go to press, the S&P 500, Hang Seng China Enterprises Index, and the CSI 300 are down 3.5%, 7%, and 6.9%, respectively, since President Trump’s May 5 tweet (Chart 1). Chart 1Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Stimulus Minus Shock Holding all else equal, the events of the past two weeks are strictly negative for Chinese economic growth and would thus justify a decisively bearish outlook for Chinese stock prices after the rally that has taken place over the past six months. However, all is not equal, because a substantial deterioration in the export outlook will invariably cause a response from Chinese policymakers. Over the coming few weeks, global investors are likely to remain highly focused on developments and announcements related to the trade conflict. But at this point, our geopolitical team believes that the conclusion of an actual trade agreement this year is now only a 40% probability. This underscores that China-exposed investors should, for the purposes of investment strategy, simply assume that the U.S. proceeds with 25% tariffs on all imports from China, and should broaden their focus to the outcome of a simple formula that describes the potential net outcome of this event. Two simple scenarios concerning this formula are outlined below: Scenario 1 (Bullish): Stimulus – Shock > 0 Scenario 2 (Bearish): Stimulus – Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. In this scenario, investors should actually have a bullish cyclical outlook for China-related assets, even if the near-term outlook is deeply negative. Scenario 2 denotes a bearish outcome where China’s reflationary response is not larger than the magnitude of the shock, which includes a circumstance where the impacts are exactly offsetting (because of the higher uncertainty, and thus risk premium, that this would entail). “Solving” The Formula In order to “solve” this formula, investors need answers to the following three questions: What is the size and disposition of the likely shock to China’s economy in a full-tariff scenario? What kind of reflationary response is required in order to offset this shock? What are the odds that policymakers will deliver the required response? Simulated and empirical estimates of a 25% increase in tariffs affecting all U.S.-China trade suggest a sizeable economic impact. Charts 2 & 3 provide the IMF’s perspective on the first question. The charts show the simulated impact of a 25% increase in tariffs affecting all U.S.-China trade, and they estimate the near-term impact for China to be -1.25% for real GDP (-0.5% over the long-run) and -3.5% for real exports (-4.5% to -5.5% over the long run).   A recent IMF working paper came up with a more benign estimate of the first year impact, but a sizeable second year impact and a similar estimate of the long-term ramifications of tariff increases.2 Using a dataset with wide time and country coverage, the aggregate results of the study imply that Chinese output is only likely to fall about 0.2% in the year following the tariff increase. However, the cumulative shock to output increased sharply to roughly 1.6% in the second year of the tariff increase, with a negative yearly impact to output persisting for 5 years (with an average annual impact of -0.6% over the whole period, somewhat higher than the estimates shown in Charts 2 & 3). At the 90% confidence interval, the author’s estimates show that a tariff increase of this magnitude would imply a -1.7% average impact on output per year in the first two years following the increase. Chart 4The IMF's Shock Estimates Suggest A Serious Hit To China's Economy In order to answer the second question, investors need to have some sense of the relative magnitude of the estimates noted above. Chart 4 provides some perspective and highlights that the estimates above, were they to materialize, would do two things: Taking Chinese real GDP data at face value, it would cause the largest deceleration in China’s real GDP growth rate since 2012, when the economy slowed significantly and authorities responded forcefully. Based on the most recent data for Chinese real export growth, a 3.5% deceleration in export volume would push its growth rate to its lowest level since the global financial crisis. In practice, we doubt that China’s reported real GDP growth rate accurately reflects what occurred in 2015, and it is very possible that a similar deceleration happened in that year. However, economic similarity to the 2015/2016 episode implies that a similar policy response may also be required, a proposition that is supported by our MSCI China Index earnings recession model. Table 1 shows a set of earnings recession probabilities, based on a model that we presented in two recent reports.3 The scenarios express the odds as a function of new credit to GDP and our calculation of China’s export weighted exchange rate, and assume a substantial decline in the new export orders component of the official manufacturing PMI, and flat momentum in forward earnings. Table 1Our Earnings Recession Model Suggests That A 2015/2016 Style Response Is Needed To Counter This Shock The table clearly highlights that a significant further acceleration in new credit to GDP, coupled with a meaningful decline in the exchange rate, is needed in order to stabilize the earnings outlook. We have previously related stability in the outlook for earnings to stability in the economy itself, given the close correlation between Chinese investment-relevant economic activity and the earnings cycle (Chart 5). Given that new credit to GDP peaked at 31.5% during the 2015/2016 episode, it seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. Policymaker Preferences Vs. Constraints This brings us to our third question: What are the odds that policymakers will deliver the stimulus required to confidently overcome the upcoming shock? It seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. If the answer was only dependent on the preferences of policymakers, the odds would be low. China has relied heavily on credit to stimulate its economy over the past decade, and Chart 6 highlights that this has come at a high cost. The BIS’ estimate of the debt service ratio of China’s private non-financial sector is already extraordinarily high relative to other countries, and another round of meaningful re-leveraging will just make this problem even worse. Chart 5Earnings Stability = Economic ##br##Stability Chart 6Further Leveraging Will Undoubtedly Make A Big Problem Even Worse   We documented in detail how this has created the risk of a debt trap for China’s state-owned enterprises in an August Special Report,4 and have presented evidence arguing that China’s policymakers appear to have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption.5 This implies that restraining credit growth to avoid further leveraging has been a reasonable policy objective during periods of relative economic stability. However, policy decisions cannot be made in a vacuum, and this is true even in the case of China. As such, instead of preferences, investors should be focused on policymaker constraints in judging likely policy actions. Given the potential for second round effects, Chinese policymakers need to calibrate their policy response to ensure a positive net impact of the stimulus minus the shock. In our view, three factors point to the conclusion that Chinese policymakers face serious economic constraints in setting their policy response: Charts 2-4 highlighted that 25% tariffs on all U.S.-China trade would constitute a meaningful shock, but it is also the case that this shock would be coming at a time when Chinese economic momentum is already relatively weak. This suggests that policymakers will have to act quickly and decisively to put a floor under economic activity. Charts 7 & 8 suggest that there are meaningful second round effects on Chinese domestic investment from external sector shocks, which raises the possibility that the impact on Chinese economic activity may be larger than Charts 2-4 suggest. Chart 7 shows that while the contribution to official real GDP growth from net exports is small, Chart 8 shows that past changes in net export contribution are reasonably correlated with subsequent changes in the contribution to growth from gross capital formation. While it is possible that this relationship is not actually causal, taking it at face value implies that the IMF’s estimate of the impact on output could be exceeded if the contribution to growth from net exports declines by 0.4% or more (holding the contribution to growth from final consumption expenditure constant). Since 2018’s change in net export contribution declined by three times this amount (1.2%), the downside risks to domestic investment from effectively quadrupling U.S. import tariffs are clear. China does not have a flexible labor market, and its political system is highly sensitive to significant job losses. Chart 9 shows that the employment situation has already seriously deteriorated in lockstep with actual economic activity, further underscoring the need for policymakers to act urgently. Chart 9The Employment Situation Is Already Deteriorating, And Will Do So Further We are open to the idea that policymakers may be able to devise a stimulative response of similar reflationary magnitude to the 2015/2016 episode without resorting to a major credit overshoot, but we are currently unable to articulate what it might be. This is an area of ongoing research for BCA’s China Investment Strategy service, but for now we assume that a credit overshoot remains the ultimate line of defense for China’s policymakers that will be deployed if the pursuit of alternative strategies fail to quickly stabilize economic activity. Investment Strategy Conclusions In our view, focusing on policymaker constraints rather than their preferences is much more likely to guide investors towards the right strategy conclusions over a 6-12 month time horizon. However, in the near-term, policy mistakes can occur, and are much more likely to occur if policymakers react to the imposition of constraints rather than anticipate their arrival. Over the coming three months, we see meaningful odds that Chinese policymakers remain reluctant to allow another episode of significant releveraging in the economy. If we are correct in our assessment of the damage that the tariff shock is likely to cause, this would set up a classic market “riot”, where policymakers are forced by financial markets to capitulate and respond forcefully to the seriousness of the economic situation. Further RMB weakness is likely. Investors should hedge their exposure and go long USD-CNH. Chart 10Investors Have A Green Light To Bet On A Lower RMB Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately deliver the stimulus required to more than offset the upcoming shock to external demand. This means that our long MSCI China Index, MSCI China A onshore index, and MSCI China Growth index trades relative to the global benchmark are explicitly cyclical in orientation, and may suffer meaningful further losses over the coming few months before ultimately recovering. As a final point, Table 1 highlighted that a meaningful decline in the exchange rate is likely required in order to stabilize the earnings outlook. Chart 10 shows that currency weakness persisted well past the trough in relative Chinese investable equity performance during the 2015/2016 episode, and we would expect a similar result in the current environment given the nature of the shock. As such, we recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade today, with high odds of a break above 7 in the coming weeks. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 The first, second, third “round” of tariffs reference the $50/$200/$300 billion tranches of imported goods subject to U.S. tariff announcements since last summer. 2 IMF Working Paper WP/19/9, “Macroeconomic Consequences of Tariffs”, by Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, and Andrew K. Rose. 3 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks,” dated January 16, 2019, and Weekly Report “A Gap In The Bridge,” dated January 30, 2019 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” dated August 29, 2018, available at cis.bcaresearch.com. 4  Please see China Investment Strategy Weekly Report “Is China Making A Policy Mistake?,” dated October 31, 2018, available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Highlights We were on the road last week, discussing our economic and market outlooks: We met with a range of Midwestern clients who focus primarily on the U.S. A majority of our meetings were with fixed-income teams. The Fed will ultimately decide the fate of the expansion, … : Nearly everyone wanted to get a read on how much longer the expansion will last. We offered the view that the Fed will induce the next recession, provided that an exogenous event doesn’t beat it to the punch. … and inflation will be the catalyst that prompts the Fed to act: Inflation was typically far from investors’ minds, and several of our meetings centered on what will drive it, and where and when we expect it will show up. Feature We traveled throughout the Midwest last week, discussing our outlook for financial markets and the economy with a range of investors. We got the sense that our clients are constructive about the economy and are generally open to tilting portfolios in a risk-friendly direction, albeit somewhat grudgingly. They recognized the challenge that worsening U.S.-China trade relations would pose to a constructive call, but were content to wait for more information before adjusting their views or their portfolios. Our views continue to follow the outline we’ve laid out in our written reports. In the absence of economic or financial market excesses, or an exogenous shock that induces a material slowdown, we expect the expansion to roll on until the Fed begins to fear that it’s gone too far and imposes restrictive monetary policy settings to rein it in. Until it does, we expect that the equity bull market will continue and spread product will deliver positive excess returns over Treasuries. The investment strategy takeaway is that it is too early to de-risk portfolios. De-risking will become the order of the day once the Fed resumes tightening monetary conditions via rate hikes. There is currently no sign that the Fed is contemplating a meaningfully hawkish shift, but we expect that inflation pressures will eventually force its hand. Ten years of subdued inflation have made a mockery of recurring post-crisis inflation warnings, and clients have developed a robust immunity to them. What, they wanted to know, has changed enough to resuscitate inflation? Steroid-Fueled Demand Aggregate demand crashed during the crisis and was far short of the economy’s capacity when it bottomed in mid-2009. In economics lingo, that meant that the U.S. economy faced a sizable negative output gap when it embarked on the recovery/expansion. Although the economy grew at a tepid 2% rate over the ensuing decade, capacity grew even more slowly, held back by consistently weak capital expenditures, and the output gap finally closed around the beginning of 2018 (Chart 1), removing a stout inflation-absorbing buffer. Chart 1The Excess Capacity Cushion Is Gone The United States then poured fuel on the fire by injecting a significant quantity of stimulus into an economy that was already operating at capacity. Corporations and other businesses that viewed the pickup in aggregate demand as a one-off event refrained from expanding capacity to meet that demand, as it appeared as if it would be a poor use of capital. Imported goods from economies that still have excess capacity can relieve some of the pressure of inadequate domestic supply, but they’re unlikely to absorb all of the pressure from excess demand, even in the absence of new tariff barriers. The aggregate 2018-19 stimulus shapes up as a catalyst for higher prices. Capacity vastly exceeded demand when the economy began to turn around ten years ago, but the stimulus package has made it look a little thin. The trouble is that no one can pinpoint exactly when upward price pressures will reveal themselves. Inflation is the mother of all lagging indicators, peaking and bottoming well after business cycle transitions suggest it should (Chart 2). All we can say is that the steroid injection from the stimulus planted the seeds of inflation. Just when they’ll begin to sprout is uncertain, but we believe the Fed’s pause will give them a chance to take root. Wage Inflation The labor market is so tight that it squeaks. The unemployment rate has fallen to a 49-year low; baby boomer retirements will cap the labor force participation rate around its current level (Chart 3, top panel); and discouraged workers (Chart 3, middle panel) and involuntary part-time workers are few and far between (Chart 3, bottom panel). Now that it has been absorbed, the glut of idled workers will no longer serve as a buffer neutralizing upward wage pressures. The labor market is tight as a drum. The pool of discouraged workers and involuntary part-timers is smaller than it was at the last two cyclical peaks, while employer demand is more robust. Employees are starting to gain bargaining power. The Job Openings and Labor Turnover Survey (JOLTS) indicates that demand for new workers is intense. As a share of total filled positions, job openings are at an all-time high in the 18-year history of the series (Chart 4, middle panel). No one quits a job unless s/he has another one lined up, and it almost always requires higher pay to induce an employee to jump from Employer A to Employer B. The elevated quit rate thus reveals that employers are poaching workers from each other to meet that demand (Chart 4, bottom panel). After Employer B lures an employee away from Employer A, Employer A hires a worker from Employer C or Employer D, which now has an opening it needs to fill. The employment merry-go-round creates a self-reinforcing cycle pushing wages higher and endowing employees with newfound bargaining power. Chart 3With Fewer Workers On The Sidelines … Chart 4… Employers Have Turned To Poaching Self-sustaining wage gains could produce price-level increases via a demand-pull or a cost-push mechanism. In a demand-pull framework, businesses observing steady payroll expansions and increased household income may well attempt to push through selling price increases. Under cost-push, corporations raise prices in an attempt to offset increased labor costs. Then again, the pass-through from wage inflation to price inflation might not occur at all, as the dynamics of inflation are not fully understood. What The Fed Believes Investors may be frustrated by the lack of a clear connection between wages and prices, but they should not be put off by a little ambiguity – there would be no alpha without uncertainty. An absence of realized inflation does not eliminate the prospect of rate hikes. Our Inflation → Rate Hikes → Restrictive Monetary Policy → Recession → Bear Market roadmap may still come to pass. The first step in the chain would simply have to be perceived inflation as opposed to realized inflation, and it’s the Fed’s perception that drives monetary policy, not the public’s. As we stressed in our Special Report on the Phillips curve,1 there is no alternative explanation in mainstream economics connecting the dots between the elements of the Fed’s dual mandate. Every mainstream economic model posits an inverse relationship between inflation and the unemployment rate. Every economist learned about the expectations-augmented Phillips curve multiple times in the course of his or her undergraduate and graduate studies. Until the profession settles on an alternative narrative, the Fed and other major central banks will be beholden to the Phillips curve. The connection between wages and prices is a mystery, but the Phillips curve’s place in mainstream economics remains secure. It’s easy to talk of patience when inflation has been hibernating for ten years, even with the unemployment rate at 49-year lows, but once wage gains begin to exceed 3.5% and 4%, we expect the Fed will change its tune. Wages do not respond to changes in the unemployment rate when there’s ample slack in the labor market, but they do once it becomes difficult to find employees. The varying sensitivity of changes in wages at different levels of unemployment explains the kink in the Phillips curve, but we found the NAIRU-based unemployment gap2 to be a reliable proxy for identifying the point at which the labor market meaningfully tightens (Chart 5). Chart 5NAIRU, … The natural rate of unemployment is only a concept, however, and the CBO series we use to calculate the unemployment gap is subject to retroactive adjustments intended to better match the CBO’s estimates with real-world observations. We therefore incorporated two alternative measures of labor market slack to test the robustness of the unemployment-gap framework. The first is the Jobs Plentiful/Jobs Hard To Get responses from the Conference Board’s consumer confidence survey. The top panel of Chart 6 calculates the difference between Jobs Hard To Get and Jobs Plentiful; when it’s positive (negative), survey respondents are indicating that the labor market is soft (tight). The disparity in wage growth between the soft and the tight states, as estimated by the hoi polloi, is a little larger than under the CBO’s revised NAIRU estimates, suggesting Main Street may be better positioned to evaluate labor-market dynamics than D Street (the CBO’s address). Chart 6… The Consumer Confidence Survey, … To get away from the arbitrariness of the unemployment rate and the uncertainty of NAIRU estimates, we considered the employment gap from the perspective of the prime-age (non-)employment-to-population ratio (Chart 7). It also supports the conclusion that wage gains are a function of the degree of labor market slack, but the outlier results from the crisis render the mean non-employment ratio since 1985 a less-than-perfect boundary between tightness and slack. The prime-age (non-)employment-to-population ratio better fits the standard Phillips curve framework, producing a solidly linear relationship (Chart 8). It points to further wage gains as prime-age employment increases. Chart 7… And Prime-Age (Non-)Employment All Point To Faster Wage Gains If productivity continues to grow by leaps and bounds – the fourth-quarter gain was impressive, the first-quarter’s was eye-popping – the Fed won’t feel much pressure to hike rates. Productivity is a function of capital expenditures; workers are able to increase output when they’re provided with more and better tools. Capex has been extremely weak ever since the crisis in the U.S. and the rest of the world, however, and we do not think that investors should count on productivity remaining much above its low 1%-plus trend level of the last several years. Investment Implications The ultimate effect of the Fed’s pause will be to extend the duration of the expansion, assuming that an exogenous shock does not pull the plug on it. Extending the expansion will have the effect of extending the equity bull market, and the period in which spread product generates positive excess returns over Treasuries. There is no free lunch, and dovishness now will be offset by hawkishness later. Larger bull-market gains will ultimately be countered by larger bear-market losses. That is a concern for another day, however, and we continue to recommend that investors remain at least equal weight equities and spread product in balanced portfolios. We do not see a recession until the second half of 2020 at the earliest. Our best guess is that it will begin around the middle of 2021, so it is too early to de-risk portfolios or shift to a more defensive asset allocation profile.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report,  “The Phillips Curve: Science Or Superstition?”, published February 26, 2019. Available at usis.bcaresearch.com. 2 The unemployment gap in the top panel of Chart 5 is calculated by subtracting the Congressional Budget Office’s estimate of NAIRU from the official unemployment rate. NAIRU, or the natural rate of unemployment (u*), is the minimum unemployment rate that would exist even in a full-employment economy. It results from structural factors like skill and geographic mismatches. The CBO currently estimates that NAIRU is 4.7%; the Fed’s dots suggest that it estimates u* is around 4.6%.  

Special Report

We are strongly committed to our 2 percent inflation objective and to achieving it on a sustained and symmetric basis. – Jerome Powell, May 1, 2019 St Louis Fed President James Bullard, a voting member of the central bank’s policy committee, said he “certainly would be open to a cut” should inflation continue to fall short of expectations after the summer. – Financial Times, May 3, 2019 The Federal Reserve’s preferred measure of prices (the core personal consumption deflator) rose by 1.6% in the year to March, a shortfall from the 2% inflation target. Moreover, the 10-year-moving average of core inflation has remained persistently below the 2% level over the past 17 years (Chart 1). Recent comments from some policymakers and market analysts highlight growing concerns about this shortfall. Personally, I see little to worry about. Chart 1Core Inflation: Not Quite At 2% For investors, high and rising inflation is a terrible thing, as is its even more evil twin, a high and accelerating pace of deflation. The Holy Grail for investors and policymakers alike is for actual inflation and inflation expectations to remain both low and stable. It seems to me that this has been achieved, with resulting huge benefits to the economy and financial markets. It matters little that inflation has fallen slightly short of the arbitrary 2% target. If inflation was problematically low, what might we expect to see? Importantly, companies would be complaining about a tough pricing environment and pressure on profits. Yet, S&P 500 profit margins are close to an all-time high (Chart 2). And that is providing powerful support to the stock market, with the S&P 500 also close to its highs. If there were building deflationary pressures in the economy, then it also would be reasonable to expect spreading signs of economic distress. While not every indicator is flashing green, the overall economy is doing just fine. Healthy employment growth, rising real wages and strong profits are more consistent with a nascent inflation problem than with deflation. According to the National Federation of Independent Business survey, small companies’ main problem is the quality of labor, not concerns about demand. Excessively low inflation is a problem for debtors, but loan delinquency rates – albeit a lagging indicator – are well contained. The Fed makes a big deal about the importance of keeping inflation expectations anchored – i.e. stable at a low level. There does not appear to be any major problem on this front. For example, the New York Fed’s survey of consumers shows median expected inflation of 2.9% in three years’ time (Chart 3). The University of Michigan Survey of Consumers shows expected inflation of 2.3% over the next 5-10 years. The gap between nominal and real 10-year Treasury yields – a proxy for financial market inflation expectations – is lower (currently 1.88%), but that measure moves around a lot and is highly correlated with oil prices. No measures of expected inflation are in free-fall or dangerously low. Chart 2No Signs Of Pricing Distress Chart 3Inflation Expectations Are Contained   What If? Suppose that the Fed had been prescient enough to realize 10 years ago that, despite its best efforts, core inflation would average only 1.6% rather than the desired 2% over the coming decade. Presumably, the Fed would have taken even more extreme actions than actually occurred, implying a bigger expansion of its balance sheet. It is unclear whether it would have been any more successful in pushing up actual inflation. But we can be sure that it would have further inflated asset prices and encouraged even more leverage in the corporate sector. Increased financial imbalances in the economy – asset price overshoots and greater leverage – would not have been an attractive trade-off to pushing up inflation by an average 40 basis points. The core problem is that monetary policy is ill-equipped to deal with the forces that have held back economic growth. A combination of demographics, high debt and slower productivity growth have limited the U.S. economy’s potential. Thus, I have a lot of sympathy for Larry Summer’s secular stagnation thesis. Yes, that implies that the real equilibrium interest rate is very low and, therefore, that monetary policy needs to be accommodative. But it also implies that force-feeding the system with easy money is more likely to lead to asset bubbles and financial distortions than to increased consumer price inflation. What About Policy Ammo For The Next Downturn? One of the main arguments for getting inflation up is to give the Fed more scope to ease policy in the next recession. In the past, the Fed has cut the funds rate by an average of around 500 basis points during recessions. Going into the next downturn with inflation and thus interest rates close to current levels means it would not take long for the funds rate reach the constraints of the zero bound. However, this also would be the case if core inflation was at or modestly above the 2% target. That is why some commentators (e.g. Olivier Blanchard and Larry Summers) have argued for an inflation target of 4% during good times in order to allow for a large fall in interest rates when times turn bad. As long as inflation is in moderate single digits, its stability probably is more important than its level. In other words, if inflation was at 4% and was expected by all economic and financial agents to remain at that level for the foreseeable future, then the economy should not perform any worse than if inflation had stabilized at 2% - and it might even perform better. However, central banks have long had the view that the higher the inflation rate, the less stable it would be. And the same logic would apply to the downside if there was deflation. For example, once inflation rises from 2% to 4%, then it could easily move from 4% to 6% etc. Given the challenges of fine-tuning monetary policy, that view has merit. Raising the inflation target is all very well, but if central banks are having trouble getting the rate to 2%, how on earth would they get it to 4%. And the same point applies if the Fed were to shift from targeting the inflation rate to targeting the level of prices or of nominal GDP. If boosting the Fed’s balance sheet from less than $1 trillion to $4.5 trillion did not get inflation to 2%, what would it take to get inflation to 4%? It is always possible to increase inflation. For example, the government could give all households a check for $10,000 that had to be spent on domestically-produced goods and services. Furthermore, assume the checks were valid only for one year and the fiscal costs were directly financed by the Fed. This would undoubtedly unleash a powerful consumer boom and a spike in inflation. And the government could keep repeating the exercise until a sustained inflation upturn took hold. But that is an unrealistic scenario except in the event of an Armageddon economic situation. And it hardly would fit in with keeping inflation stable at a modestly higher pace. A recession is very likely within the next couple of years and monetary policy will indeed face major constraints on its actions. We undoubtedly would see renewed quantitative easing on a heroic scale with an expanded range of assets purchased by the central bank. And advocates of Modern Monetary Theory may well have their wishes granted with direct monetary financing of fiscal deficits. But, as already noted, policymakers would face these policy challenges regardless of whether inflation was modestly below or above the 2% target. Be Careful What You Wish For The Fed spent three decades squeezing inflation out of the system. In the 1970s and 1980s, high inflation expectations were deeply embedded in the behavior of consumers, companies and investors. It was a long and at times painful process to change that psychology. With inflation expectations now in the range of 2% to 3%, the Fed can claim success. Why would they want to risk undoing that achievement? Letting the economy run hot to try and offset sub-2% inflation with a period of above-2% inflation would be a dangerous strategy. History shows us that central banks have both limited understanding of the inflation process and limited control over the economy. If policymakers were successful in raising inflation, they run the risk that expectations would no longer be anchored. Moreover, the Fed would have a massive problem in communicating the logic of a pro-inflation strategy. Having spent so long in selling the message that low and stable inflation is the best way to maximize long-run economic growth, it likely would create considerable confusion to then say that a period of higher inflation was acceptable. Investors and businesses would face huge uncertainty about the magnitude and duration of an inflation overshoot and about whether the Fed could even control the process. The Fed’s credibility undoubtedly would suffer. It is true that policymakers know how to bring inflation back under control – they simply have to tighten policy. But that introduces increased instability into the economy and financial markets. Rather than be obsessed about hitting the 2% target, policymakers should be happy that they have met the requirements of the Federal Reserve Act: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Policy Outlook And Market Implications The Fed was right to stop raising interest rates. The economy does not appear to be on the verge of overheating and there are enough risks to the outlook to warrant a cautious wait-and-see approach to policy. Yet, I am somewhat troubled by the dovish tone of some Fed officials. Thank goodness President Trump’s recent choices for Fed Board positions are now out of the picture. If I am worried now, I can only imagine how much worse I would have felt with Stephen Moore and Herman Cain on the Board. With no recession on the horizon and the labor markets extremely tight, I fully expect to see inflation gather steam later this year. But I suspect that the Fed will be slow to react. And then the timing of the 2020 elections will become a factor. The FOMC is not particularly sensitive to political considerations, but this is no ordinary President. The Fed would have to be very sure of itself before it started raising rates again in the midst of the election cycle. The bottom line is that we are setting up for a monetary policy error with the Fed falling behind the inflation curve later this year or in early 2020. This will be positive for risk assets in the short run, but poses a big threat down the road. Notwithstanding our concerns about the near-term market impact of current U.S.-China trade tensions, our strategy is thus to remain overweight equities and corporate credit until we see signs that financial conditions are about to significantly tighten.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com