Fed View: Negative rates not impossible, but still unlikely – Markets have moved in recent days to price in a further rate cut by the Fed, with as much as 6bp in cuts priced in for December by OIS forwards last Thursday, and the 2y yield falling past the previous all-time low of 0.14% set in September 2011 to 0.10% on Friday. Markets have since retraced as a number of Fed officials (including Bostic, Evans and Kaplan) poured cold water on expectations for an additional cut, but there is still c.3bp of easing priced by year end (put another way, 15% chance of a 25bp cut). Fed Chair Powell will speak in a webinar tomorrow, where he is likely to give more insight into the Fed’s views on negative rates.
Why is the Fed so opposed to negative rates? A key policy paper last year by leading economists influential among Fed officials explained the rationale. First, their econometric analysis finds that a -0.25% fed funds rate (i.e. 35bp below current levels) would have only limited accommodative effects in the US, lowering the unemployment rate by only 0.2pp and having ‘virtually no effect’ on inflation. Second, the paper casts doubt on whether even this small benefit might be overstating the true effect, due to negative side effects on the banking system and – unique to the US – the highly significant money market funds industry. The key concern is that the compression of net interest margins could reduce the incentive to lend, having a potentially contractionary effect on credit growth (this is something the ECB has countered via its TLTROs, which could be an option for the Fed). One area where negative rates might provide a more clear benefit is by weakening the currency. This appeared to be one of the main motivating factors behind the ECB, SNB and BoJ’s shift to negative rates. While such a goal might also have relevance for the US, it is a much less export-dependent economy than those of the other central banks, and so the desire for a weaker currency is likely to weigh less among Fed policymakers. With that said, currency could become a bigger motivating factor in a very negative macro scenario which leads to a surge in dollar demand due to increased risk aversion.
All told, while there are certain circumstances in which negative rates become a viable option for the Fed, for the time being they look unlikely – at least not before other policy options are exhausted. We think more likely options for a Fed wanting to provide more accommodation include: expanding the breadth and pace of asset purchases, stronger forward guidance, and potentially caps on bond yields. (Bill Diviney)
US Macro: Record fall in core inflation; more weakness to come – Core inflation fell by 0.4% mom in April, far below our and consensus forecasts (0.0% and -0.2% respectively), and the biggest monthly fall in the CPI’s 63 year history. Headline inflation also fell sharply, by 0.8% mom, with plunging energy prices comfortably offsetting the biggest jump in food prices since 1974. The largest component of core inflation – shelter (i.e. housing rents) – was flat on the month, as expected, however we underestimated the degree of falls in apparel, car insurance and airfares, which all fell at the fastest monthly pace on record. All of this took annual headline inflation down to a near 5 year low of 0.3% yoy, and core CPI to a 9 year low of 1.4%. Looking ahead, we expect a widespread freeze in rents to drive further declines in annual inflation over the coming months, with core CPI inflation falling to as low as 0.5% yoy by next February. We expect core PCE – the Fed’s primary focus – to be more stable due to the much higher weighting of medical vs housing costs in that index. However, the building disinflationary pressure will certainly be of significant concern to Fed policymakers, particularly if it leads to a de-anchoring in longer term inflation expectations. See a summary of our new inflation forecasts below. (Bill Diviney)
ABN AMRO US inflation forecasts