Morgan Stanley: We (Still) Need To Talk About The Fed And China

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Authored by Chetan Ahya, Morgan Stanley chief economist and global head of economics

Some debates fizzle out quickly, while others linger. This year, the Fed’s policy and the outlook for China have dominated macro conversations. The latest iteration of these debates centers on potential shifts in the Fed’s and China’s policy stance.

Going into this week’s FOMC meeting, some investors were debating about the prospects of an “insurance cut”. We saw the bar for a cut as being higher as low core inflation would need to be sustained and/or come with a deteriorating growth backdrop. Moreover, alternative inflation trend measures (e.g., the Dallas Fed’s trimmed mean price index) do not confirm the sharp deceleration in core PCE. Indeed, the prospects of an insurance cut have diminished following Chair Powell’s comments that transient factors are affecting inflation.

Post the meeting, Fed futures are still implying some (albeit lower) probability of a rate cut by the end of this year. If financial conditions stay easy and supportive of growth, we think the debate will shift to the timing of a return to a tightening path. While our Chief US Economist Ellen Zentner sees an eventual resumption of tightening, she expects the Fed to remain on hold for the next 12 months.

We don’t think inflation pressures will force the Fed’s hand, as we only forecast core PCE inflation to reach 2.0% by end-2019. With its renewed commitment to a 2% inflation goal on a “sustained and symmetric basis”, we don’t see the Fed taking action the moment core PCE inflation touches 2%. The Fed is likely to tolerate a modest and brief overshoot.

If inflation doesn’t force the Fed’s hand, will financial stability concerns push it back onto a tightening path? Providing the Fed’s latest assessment of financial system vulnerabilities, in his post-FOMC press conference Chair Powell reiterated that they remain “moderate”. Moreover, in specifically addressing financial stability concerns, while the responsibility lies with the Financial Stability Oversight Council, the Fed is likely to communicate that it would prefer macro-prudential norms (such as the counter-cyclical capital buffer tool that is under the Fed’s purview) over rates as the first line of defense, particularly if core PCE inflation is still tracking below 2%.

Turning to China, some investors see recent commentary from policy-makers as a sign of a hawkish shift. But as our Chief China Economist Robin Xing notes, the policy stance remains pro-growth, and fiscal policy will continue to be the key lever. To be clear, we don’t see the policy-makers’ emphasis on watching for financial stability risks as signalling a reversal in their position.

Moreover, the easing measures announced so far are significant and will be implemented as proposed. For instance, the Central Financial and Economic Affairs Committee meeting recently affirmed the intention to fully implement the US$250 billion fiscal stimulus. Monetary policy support will be relatively more passive, but will accommodate the government bond issuance associated with fiscal easing.

Keeping the big picture on China in mind, the policy objective of stabilising the labour market has not yet been achieved. We think that policy-makers are unlikely to declare victory on this front, hence we don’t see a shift in China’s policy stance any time soon.

Even investors who believe in the stimulus and its impact on China’s growth have questioned their benefits to the rest of the world. Some are suggesting that in this cycle what happens in China stays in China. However, in today’s world of integrated global supply chains, a pick-up in any large economy’s domestic demand will show up in imports too, benefiting the rest of the world. The impacts of a recovery in China tend to appear with roughly a three-month lag. As it is, we’re already seeing tentative signs of spillover with Korea’s exports picking up, and its PMI also. An additional transmission channel will be the impact of stronger economic activity on the domestic operations of multinational companies within China.

In sum, our view is that policy support in China and the US is unlikely to be withdrawn in the near term. With growth in the world’s two largest economies improving, we are confident that the global economy has troughed in 1Q19 and is on a recovery path. As for risks, I am more concerned about the potential re-emergence of US-EU trade tensions than an earlier-than-expected end to US and Chinese policy support.

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