Fed/ECB Watch: How much potential for surprise this year in Jackson Hole?

Is it enough? The Fed has tightened monetary policy at an unprecedented speed, raising the Federal Funds Rate by 525 basis points in a bit over a year. The US economy, however, has proven to be rather resilient to the Fed's tightening so far. GDP growth was reported at 2.4% for the second quarter (qoq, annualized), which is above potential, and for the third quarter the limited information we have so far, point towards an acceleration rather than deceleration of business cycle dynamics (GDPNow). US economic data have exceeded expectations by quite a margin in recent weeks (chart), all negating the recession calls, which were so prominent a few months ago. At the same time, the signs that inflationary pressure is losing steam intensified. Core inflation momentum has decreased to 0.2% in June and July (mom, sa, CPI), a level which is consistent with the Fed's 2% inflation target. No recession despite aggressive tightening and inflation finally coming down — is this the best of all worlds? Or, is it too good to be true? On the one hand, softer inflation dynamics might be short-lived and the economy's resilience might be a sign that the Fed's tightening must continue to push inflation back to target. On the other hand, the economic slowdown might be only delayed, and it is actually too early to point towards the US economy's resilience. Recent softening in survey indicators (e.g. PMIs barely above 50) could be seen as supporting evidence. That's the dilemma the Fed faces. It needs to find the right balance between the risk of overtightening — doing too much — and the cost of an insufficient tightening — doing too little.

US economy proves to be more resilient than expected

weekly data

Source: Refinitiv, Citi, RBI/Raiffeisen Research

Beyond the day-to-day business of monetary policy central bankers and academics will exchange views on "Structural Shifts in the Global Economy" in Jackson Hole, which is this year's official theme of the symposium set for Aug. 24 to 26. Discussions on the so-called natural rate of interest, also known as R-star, are likely to be part of the debate. R-star reflects the (theoretical) neutral real short-term interest rate at which monetary policy is neither accommodating nor restricting the economy (i.e. the economy is delivering growth at the potential rate with inflation at or close to the central bank target). In the current environment, the Fed clearly wants to set monetary policy well within restrictive territory to put downward pressure on inflation by restricting aggregate demand. What is well established in the academic literature is the fact that R-star is time-variant and has decreased since the mid-1990s. A hot topic now, however, is whether R-star has increased due to structural changes triggered by the COVID-19 pandemic. Measured against pre-pandemic estimates of R-star the Fed's policy is well within restrictive territory. The Fed's own projections of the longer-run level of the Fed Funds Rate — currently at 2.5% — reflects the view that we remain in world of low R-star. Should R-star have risen the Fed might be less restrictive than it currently thinks. Recent research by economists at the New York Fed leans into this direction. Estimates of R-star should, however, be treated with caution as it is not only the case that estimates are subject to large uncertainty bands but also different modeling approaches yield (very) different results. Still, this evidence points to the fact that there are risks that the Fed might need to do more.

The Fed's data dependent approach can be seen in light of this uncertainty how restrictive monetary policy actually is. Given the time lags with which monetary policy affects the real economy, it is, however, also tricky to fine-tune monetary policy based on incoming-data alone. A complementary approach to balance the risks of doing too little and doing too much is to emphasize a longer period of restrictive policy rates, higher-for-longer. Talking down rate cut expectations is also a form of monetary policy tightening. We see the focus to increasingly shift towards the length of key rates at the terminal rate. Also, on bond markets, this has been the driving force as of late. Longer-term yields, in particular, increased while the upside pressure on the short end of yield curves was less severe — yield curves steepened as a result. It was, thus, not the terminal rate level which was behind yield dynamics but the timing of rate cuts and the longer-run level of key rates. While the Fed will emphasize the need to stay restrictive for as long as necessary, we don't think the Fed will signal any expectations of a higher longer-run rate. For that the empirical evidence is still too vague. But the Fed can no longer surprise or call off the markets in Jackson Hole after the de facto acceptance of the higher-for-longer narrative by financial market participants in recent weeks. Previously, one could think that the markets were playing against the Fed in terms of interest rate expectations.

Bond market start to price risks that it could be back-to-NEW-normal

* based on short-term forwards of OIS curve; FOMC projections as of June 2023;

Source: Refinitiv, RBI/Raiffeisen Research

The ECB — with a certain delay compared to the Fed — has also tightened its monetary policy at an unprecedented pace, raising the key rate by 425 basis points in just over a year. In contrast to the US economy, the European economy is already clearly showing signs of weakness — even if these are not necessarily related to monetary policy yet.

This time around we do not expect any fundamental monetary policy stance realignments to be delivered by ECB officials in Jackson Hole, in contrast to the focus on the robust control approach to inflation delivered last year (which laid the foundation for decisive monetary policy action). However, ECB (Lagarde) is likely to emphasize that Europe and the euro area inflation outlook are strongly affected by structural changes in the global economy. ECB President Lagarde could focus on the fact that this could potentially translate into longer-term (structural) inflation risks for the European economy.This train of thought would also argue in favor of "higher interest rates for longer". Moreover, the ECB could underscore that its robust control approach to inflation may well translate into economic costs/losses. This could signal the ECB's determination to fight inflation, although some market participants see a September rate hike as less likely after the latest batch of leading indicator and data releases. .

In addition, the ECB is also likely to focus on its data-driven monetary policy stance, whereas monetary policy in Europe in particular has long been on autopilot compared with the United States. Moreover, it is possible that the ECB could give an indication of how it intends to deal with the further reduction of unconventional monetary policy stimulus — even when the end of the interest rate cycle will be reached. After all, the Fed recently gave some interesting hints in this regard. The US central bank can imagine a continuation of quantitative tightening (QT), even in a phase of interest rate cuts. To maintain the same restrictive extent of policy rates in inflation-adjusted (real) terms, the Fed could make cautious policy rate cuts, which would not counteract a continuation of QT.

• This year's Jackson Hole symposium (with speeches by Jerome Powell and Christine Lagarde) might form the official start to the discussions about the long-term monetary policy implications of the COVID-19 pandemic shock. Already relevant today, is whether the neutral interest rate has increased. If true, the Fed's (or ECB's) monetary policy stance might be less restrictive as policymakers think it is.
• So far, the evidence is mixed. The US economy might indeed be more resilient to interest rate shocks — and thus higher key rates might be necessary — but it could also be the case that more headwind is already in the pipeline — posing risks of overtightening. In contrast to the US economy the euro area economy is disappointing. Inside the euro area the risk of overtightening is mainly driven by the prominence of the monetary transmission via the banking sector. In regard to the latter the ECB has embarked on an unseen wind-down of unconventional monetary policy measures.
• These considerations and uncertainties are behind both central banks' emphasis on data-dependency. Taken literally, however, a data-dependent monetary policy stance risks overreacting to short-term news. Complementing this data-dependent approach with an emphasis to spread the restrictive phase over a longer period, so called higher-for-longer, allows some buffer (but requires credibility). Moreover, such a strategy allows of a separation between the short-term monetary policy stance and long-term considerations.
• In the current phase of the Fed's and ECB's fight against inflation, we see a key priority to keep a high degree of flexibility. At the moment, inflation remains too high and disinflationary forces are too tentative for the Fed and the ECB in particular. Therefore, a soft hawkish bias, which higher-for-longer delivers, might be the way to go. Thus, the gates toward interest rate hikes are likely to remain open for both major central banks in September. We would not expect any guidance that the peak in interest rates and monetary tightening will certainly be reached (very) soon.
• Bond markets, too, have recently focused on higher-for-longer and yield curves steepened (got less inverted). This, however, means no end to elevated bond market volatility in response to economic news. Possibly, investors are also finally pricing in higher/more elevated risk premiums given elevated interest rate markets volatility seen of the last few months.
• All in all, we think that leading central bankers will focus on the complexity of their monetary policy mandates within the current global economic environment during their remarks in Jackson Hole. In central banking slang: The linkage between inflation, growth and interest rates has changed, became more complex and is possibly still under-researched. We would not expect any more concrete info on where major central banks are seeing estimated neutral rates (R-star), the latter being a key variable for financial markets overall.