Policy divergence and the week’s monetary policy decisions

With the latest Fed and ECB rate policy decisions now behind us, we can start to assess what monetary policy means for the near-term future. I continue to be encouraged by near-term data flow in the US. Nothing in it reads recession. Initial jobless claims remain low, for example. In fact, some the data bits are looking bullish. For example, housing starts have hit a 12-year high according to data released yesterday.

And, if you look at the yield curve, even market-based markers of recessionary distress like the 2-10 year Treasury spread inversion are absent. The 3 month – 30 year inversion has not just reversed. It is 30 basis points to the good. It’s the 3 month – 10 year inversion which persists. And I see that more as a reflection of future rate cuts than a harbinger of recession. I am still watching for the 5-7 year inversion as a signpost of recession. And that has yet to happen once.

So, the picture you are seeing is one of data divergence. Where Europe is struggling with negative prints on the PPI in Germany today, declining car registration numbers on Wednesday and a poor ZEW sentiment read on Tuesday, the US data are looking better. In some senses, one could even say the data justifies policy divergence between the Fed and the ECB.

Policy Divergence is the Watchword

But policy divergence is dangerous, especially when it buoys the US dollar. The recent hullabaloo about the repo market in the US is a case in point. Everyone is acting like it’s a sign that the Fed has lost control of the yield curve and that rate policy isn’t working anymore. But, the real takeaway is that there is a shortage of dollars requiring Federal Reserve liquidity that the Fed somehow failed to generate. And once the Fed does its job, the repo uproar will go away.

The takeaway from the repo problem is that the Fed’s policy rate is too high relative to other central banks. And this is causing problems. And these problems spilled over into plain sight in the repo market. That’s my take. The Fed simply needs to boost reserves by running open market operations. And in short order, the problem will go away since they can inject an infinite amount of reserves into the system if they wanted to. But the fact that they need to even do this is a signpost of policy divergence.

I don’t think the Fed cares about policy divergence though. If you look at the dot plot, only 5 officials actually wanted a 25 basis point cut. And so while another 7 wanted 50, 5 more actually wanted to stand pat. That’s not a consensus telling you policy divergence matters to the Fed. It’s an extreme lack of consensus on US rate policy and a moderate hedge of 10-7 toward maintaining divergent policy.

At the FOMC press conference one of the last questions was on this very matter:

Hi, Heather Long from the Washington Post. Mr. Chairman, in your view, is there any risk to the United States having much higher interest rates than Europe, and Japan, and other parts of the world? Is there any risk to the U.S. Economy to that divergence or any risks to the global economy?


Yeah, so I guess I would say it this way. Global capital markets are highly integrated, and our long rates are definitely being pulled down by the very, very low rates that are abroad. The way I would characterize it is this, that low rates abroad are a sign of weak global growth, expectations of low inflation, low growth, and a lack of policy space to move against, or ideas about how to break out of that low equilibrium. Now, that has implications for us. In a world where we’re economies and financial markets are tightly integrated, that matters for the U.S. economy. So that’s going to pull down U.S. rates, and U.S. financial conditions can tighten because of that, and so I think all of that goes into our thinking and into our models. We do understand how the international sector interfaces with the U.S. Economy. We take that into account in setting our interest rate policy.

I would give Powell a B+ for his answer. He acknowledged the policy divergence issue as important. But I am still left feeling like it’s not a big factor in the Fed’s policy rate decision-making.

My view

The data flow has let the Fed off the hook. The need to cut aggressively seems less obvious based on US macroeconomic data. And so, this sets the US up as the major central bank most at odds with the policy direction globally. It also likely means the US dollar will remain strong.

Going forward, we need to watch for signs that this is leading to economic or financial distress. As far as the US goes, though, the numbers are pretty good. This expansion has legs. I continue to see no recession in 2019. 

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