Central Bank Meeting Confirms Need for Further Tightening

Monetary prudence will support growth and avoid a destabilizing bubble
September 2, 2018 Updated: September 3, 2018

If we analyze the consensus expectations of analysts and investment banks at the end of 2017, the conclusion was unanimous: buy Europe and emerging markets against the United States, amid weakening dollar estimates in 2018.

It has been exactly the opposite.

We’ve already warned a few times about the risk of such a biased consensus toward a weak dollar. The reality is that Europe showed a decline of almost 3.5 percent, led by banks, while emerging markets plunged almost 20 percent. Meanwhile, the United States marked record highs, with the dollar recovering much of what it lost in 2017.

What does this tell us about the next few months? We must ignore the “crowded trades” and look for value in a different way.

The strength of the U.S. economy is evident, especially compared to a clear slowdown in the eurozone, Japan, and China, as well as emerging markets. However, we must avoid complacency. The rise in wages has been consumed almost entirely by inflation, and the last data of durable orders recorded a decline in July that we can’t ignore. Despite this, the United States will probably grow more than 2.8 percent in the third quarter.

The Limits of Central-Bank Planning

The Jackson Hole meeting showed us something that we have already experienced in the past: mixed messages and a poor capacity of predicting near-term growth. When I presented “Escape from the Central Bank Trap” at the Federal Reserve in Houston, I mentioned the poor medium-term forecasts of the central bank. In both inflation and growth, its predictive ability has been more than disappointing.

It makes sense then that the message at this Jackson Hole meeting was, again, mixed. On the one hand, the path of rate hikes is confirmed, but very little analysis has been done on the risk of excess stimuli.

The Fed remains behind the curve, so we shouldn’t be surprised that the increase in the money supply in the first half of the year has more than offset the modest reduction of the Fed’s balance sheet. This fact is very important to debunk those that blame the Fed for the collapse of emerging markets.

These nations have experienced a self-inflicted collapse after years of building imbalances, and this trend cannot be attributed to such a modest normalization of monetary policy—so modest that M2 money supply has grown in the United States faster than real GDP.

Investors, therefore, cannot expect a bailout from U.S. central bankers after excess complacency regarding emerging markets. The challenges of most of the emerging economies have nothing to do with a modest rise in rates, which have been announced ad nauseam. They have to do with the same historical mistakes: thinking that fiscal and commercial imbalances won’t generate a recession because everyone else does the same.

The message from the Jackson Hole symposium shows nothing but continuity, as the Fed always seeks to offer. Neither criticism of a strong dollar nor investor losses in emerging markets are going to stop the path of more rate hikes.

The Fed has to accumulate tools before a cycle change and, above all, it has to recover the time lost during Janet Yellen’s mandate. She lost golden opportunities to raise rates, due to her unjustified fears of the political calendar and the markets.

The Time Is Now

The Fed remains behind the curve. It needs to hike rates fast because the biggest risk for the U.S. economy isn’t interest rates, but the chain of bubbles and excess risk built into financial markets.

Recessions don’t happen because the Fed hikes rates, but because it hikes too late, when complacency reaches unsustainable levels and high risk-taking and bubbles become threats to the real economy. When they finally burst, they create a negative ripple effects in jobs and growth, leading to a recession.

Europe isn’t affected by U.S. rate hikes or policy normalization, but the region is falling into the same complacency trap before the end of the European Central Bank stimuli. The slowdown of the main economies is normal and a consequence of a model that limits growth, not monetary policy.

European countries have all but abandoned any hint of reform, and countries such as Italy and Spain are announcing large increases in deficits, just as rates are about to rise and the eurozone is facing 1 trillion euro in maturities. The ECB can disguise structural problems for a while but not forever.

Nothing seems to indicate a risk of crisis or a serious recession in the short term. What we are facing is simply the moderation of completely optimistic and artificially euphoric estimates. Considering the almost concerted actions of central banks, we are much more likely to enter into a period of stagnation than a 2008-type crisis.

In other words, those calls for “synchronized growth” and science-fiction estimates will face the reality of synchronized indebtedness and debt saturation.

Jackson Hole isn’t going to bail out investors or politicians from the bad decisions of recent years, because everyone at the Fed knows they have something more important to do: defend sustainable U.S. growth and avoid building a larger bubble that leads to a deep crisis. Considering the risks generated during the quantitative-easing years, this is a difficult task.

The economic figures of the United States are largely positive, but we forget that what can derail the economy comes more from the excess of complacency in financial assets than current macro data. Fed officials should know that recessions start when economic agents are too exposed to excess debt.

China Made Its Own Bed

China has carried out a devaluation that doesn’t solve its important internal problems. The central bank already has injected more than 130 billion yuan into banks to try to cover the risks. Instead of advancing in structural reforms, it has reduced capital requirements, encouraging the excess of indebtedness.

Devaluation doesn’t solve its problems; it accelerates them. A 10-percent tariff affects a very limited percentage of the economy. On the other hand, a 10-percent devaluation impoverishes all Chinese citizens and worsens their ability to repay debt because fixed costs aren’t devalued, and the cost of living rises much faster than official inflation.

Powell’s Fed isn’t the same as Yellen’s or Ben Bernanke’s. It should not use policy to facilitate the expansion of the bubble in financial assets, emerging-market debt, or China. It should take action to avoid the excesses built into the domestic economy.

We already saw the risk of inaction with Yellen and Bernanke, missing exceptional opportunities to truly normalize monetary policy. Because of that, there are collateral damages—excess risk-taking, high leverage in financial assets—that are now evident.

Jackson Hole shouldn’t be a catalyst for the markets to rise. If it is, the Fed hasn’t done its job correctly. Emerging economies shouldn’t bet on the Fed to bail them out by fueling the bubble, but begin to solve their serious imbalances without expecting monetary miracles.

The Fed isn’t going to rescue inefficient economies. It has never done that. Disguising risks with excess optimism doesn’t eliminate them; it only makes the landing harder and more complicated.

