Global Daily – Could the Fed adopt a new policy framework?

by: Bill Diviney , Arjen van Dijkhuizen

Fed View: A high bar for radical changes to the policy framework – There is an active debate at the Fed over options to overhaul the 2% inflation targeting framework, which has continued this week with a contribution from Atlanta Fed President Bostic (see here). The debate has been driven by the concern that with the neutral rate so low (in the 2.5-3% range), the Fed will lack sufficient firepower to respond to the next downturn using conventional policy. Among the options for changing the framework, such as raising the inflation target, or adopting an inflation target range, a leading candidate is price level targeting – in other words, when inflation under- or over-shoots the 2% target, that the Fed will not ‘let bygones be bygones,’ but seek to make up for past deviations from the target. Such a regime could better anchor inflation expectations, by formalising the symmetry of the Fed’s 2% target.

The main drawback would be that, having established credibility with inflation targeting, the Fed would be taking a risk moving to an entirely new framework. It would also involve greater volatility in inflation if the Fed had to make up for significant deviations from a price level target. We think former Fed Chair Bernanke’s proposal of ‘temporary price-level targeting’ is probably the most feasible option. It essentially amounts to a strengthened form of forward guidance that applies only when the Fed is at or near the zero lower bound, and is compatible with the existing framework (see here). We can likely expect further proposals for policy framework changes by FOMC members over the coming months. However, we think there will be a high bar for the Fed to switch to a radically different framework. (Bill Diviney)

Global Trade: US-China trade frictions still in focus – Weakness in equity markets have given a haven bid to bond markets over the past 24 hours. While there appear to be some sector-specific drivers of the risk aversion, ongoing concerns over US-China trade tensions are likely another driver. Following the Section 301 investigation on intellectual property theft and forced technology transfer by China, the US might later today publish a more concrete list of goods for proposed import tariffs. President Trump has also asked China to make a plan to reduce its annual bilateral surplus with the US by USD 100bn, which rose to a record USD 375bn in 2017. Meanwhile, the President announced that the US would work on tightening foreign investment regulations. Allegedly, the US might take measures directed at ten of China’s strategic high-tech sectors, the pillars of the Made in China 2025 strategy. So far, China’s reaction has been measured. On 23 March, it proposed retaliatory tariffs on USD 3bn of US exports to China (mainly agricultural products). China also stated that further measures could be worked out if the US would indeed proceed with the Section 301-related tariffs. Today, Reuters reported that according to the Global Times – run by the official People’s Daily – China would soon present a wider list of tariffs on US exports to China. Despite the threats and counter-threats, we continue to expect the US and China to come to a negotiated outcome (see here). (Arjen van Dijkhuizen and Bill Diviney)

China Macro: Trade war escalation would weigh on China’s growth, but not (yet) our base case – In our base scenario, we assume that the US and China will succeed in reaching a negotiated deal. To achieve that, we think China can offer a number of concessions, such as the opening up of Chinese strategic sectors (including the insurance and other financial sectors) to US firms and measures to support US car and semiconductor exports to China. Such measures would help reduce the politically sensitive bilateral deficit of the US with China. Even if such a deal would fail to materialise and the US and China would proceed with import tariffs and a tightening of investment regulations, we still think that the short-term impact on Chinese GDP growth would be marginal (USD 50-60bn is only 2.5% of total Chinese exports in 2017 – see here). That said, there are still uncertainties and risks of escalating trade tensions, also reflecting broader US concerns that it will lose its technological superiority partly due to unfair Chinese practices. We have previously sketched out how an escalating trade war could affect the outlook more broadly (see here). For China specifically, we estimate GDP growth for 2018 (our forecast: 6.5%) could be impacted by roughly 0.5pp. We should add that these are ‘ceteris paribus’ calculations, as in practice China may work on diverting its exports away from the US, while Beijing might decide to soften its targeted tightening campaign or even switch to a ‘targeted easing’ mode if needed. (Arjen van Dijkhuizen)