Central Banks' Diverging Paths: Reflation vs. Deflation

Morgan Stanley’s chief economists take stock of a resilient global economy that has weathered a recent period of market volatility, in Part I of our two-part roundtable.

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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist. And on this special episode of the podcast, we'll hold our third roundtable discussion focusing on Morgan Stanley's global economic outlook as we enter the final quarter of 2024.

I am joined today by our economics team from three regions.

Chetan Ahya: I’m Chetan Ahya, Chief Asia Economist.

Jens Eisenschmidt: I’m Jens Eisenschmidt, Chief Europe Economist.

Diego Anzoategui: I’m Diego Anzoategui from the US Economics team.

It's Monday, October 7th at 10 am in New York.

Jens Eisenschmidt: And 3 pm in London.

Seth Carpenter: I have to say, a lot has happened since the last time we held this roundtable. To say the very least, we've had volatility in financial markets. But on balance, I kind of have to say the global economy has more or less performed the way we expected.

The US economy is cruising towards a soft landing. The labor market maybe is a touch softer than we expected, but consumer spending has remained resilient. In Asia, Japan's reflation story is largely intact, while China is still confronting that debt deflation cycle that we've talked about. And in Europe, the tepid growth we had envisioned -- well, it's continuing. Inflation is falling, but the ECB seems to be accelerating its rate cuts. So, let's get into the details.

Diego, I'm going to start with you and the US. The Fed cut interest rates in September for the first time this cycle, and they cut by 50 basis points instead of the 25 basis points that some people -- including us -- were expecting. So, the big question for you is, where does the Fed go from here?

Diego Anzoategui: So, we are looking for a string of 25 basis point cuts from the Fed as long as labor markets hold up. Inflation has come down notably and we expect a normalization of interest rates ahead. But, of course, we might be wrong again. Labor markets might cool too much, and in that case, one or two additional 50 basis point cuts might happen again.

Seth Carpenter: So, either the Fed glides into the soft landing or they pick up the pace and they cut faster.

So, Jens, let me turn to you and pivot to Europe. You recently changed your forecast for the ECB, and you're now looking for a rate cut in October. And that's following two cuts already that the ECB has done. So, what prompted your change? Is it like what Diego said about a softer outcome prompting a faster pace of cuts. What's likely to happen next for the ECB?

Jens Eisenschmidt: That's right. We changed our ECB call. And to understand why we have to go back to September. So already at the September meeting the ECB president, Lagarde, made clear in the press conference that the bank was a little bit less concerned about structurally high services inflation that is forecast to be persistently high still for some time to come -- mainly because there was more conviction that wages would come down eventually.

And so, they could really focus a little bit more, give a bit more attention to the growth side of things. Just as a reminder, the Fed has a dual mandate. So, it's growth and inflation. The ECB only has inflation. So basically, if the ECB wants to act on growth, it needs to be sure that inflation is under control. And then since September what happened is that literally every single indicator, leading indicator, for inflation was negative. We had lower oil prices, we had a stronger euro, and of course, also weaker activity in terms of the PMIs pointing to a cooling of the ongoing recovery.

So, all of that led us to revise our inflation forecast, and that means that ECB will very likely already be a target mid next year. That should lead to an acceleration of the rate cut cycle. And then it's only a question, will it be already in October or in December? And here comes the September inflation print in, which was softer in particular on the core or on the services component than expected. And we think that has tilted the balance; or will tilt the balance in favor of an October rate cut.

So, what we see now is October, December, January, March -- 25 basis points rate cuts by the ECB leading to a rate of 250. Then this being close to neutral, they will slow down again, quarterly rate cut pace. So, June, September, December, 25 basis points each -- leading to a final rate end of next year at 175.

Seth Carpenter: Okay, got it. So, inflation has come down in most developed market economies. Central banks are starting to cut. For the Fed, there's an open question about how much strength the labor market still has and whether or not they need to do 50 basis points or 25.

But I have to say, Chetan -- and I'm going to come to you because -- in Asia, we saw a lot of market turmoil in August, and that was partly prompted by the rate hike of the BoJ. So, here's a developed market economy central bank that's not cutting. In fact, they're starting to raise interest rates. So, what happened there? And what do you think happens with the BoJ going forward?

Chetan Ahya: Well, Seth, in our base case, we do expect BoJ to hike by another 25 basis points in January next year. And as regards to your question on what happened in terms of the volatility that we saw in the month of August? Essentially, as the BoJ took up its first rate hike, there was a lot of concern that BoJ will go in a consecutive manner, taking up successive rate hikes. But at the end of the day, what we saw was, BoJ realizing that there is a clear endogeneity between financial conditions and their reaction function. And as that communication was clearly laid out, we saw markets calming down. And now going forward, what we think BoJ will be watching will be the data on inflation and wages.

We think they would be waiting to see what happens to the inflation data in the month of November and October, i.e., whether there is a clear, rise in services inflation, which has been running at around 1.3 per cent. And they would want to see that wage pass through to services inflation is continuing.

And then secondly, they will want to see what is happening to the wage expectations from the workers in the next round of spring wage negotiations. The demand from workers will be clear by the end of this year, so sometime in December. And therefore, we think BoJ will look at that information and then take up a rate hike in the month of January next year.

Seth Carpenter: Okay, so if I step back for a second, even if there are a few parts of the puzzle that still need to fall into place, it sounds to me like you're saying the Japan reflation story is still intact. Is that fair?

Chetan Ahya: That's right. We think that, you know, the comment from the prime minister that came out a few days back; he's very clear that he wants to see a situation where Japan gets rid of deflation. So, we think that the policymakers are fully lined up to ensure that the reflation story remains intact.

Seth Carpenter: That's super helpful and it just absolutely contrasts with what we've been saying about China, where they have sort of the opposite story. There's been a debt deflation cycle that you and the Chinese team have really been highlighting for a long time now, talking about the challenges for policy.

We did get some news out of Beijing in terms of policy stimulus. Could you and break down for us what happened there and whether or not you think that's enough to really shift China's trajectory away from this debt deflation cycle?

Chetan Ahya: Yes, Seth, so essentially, we got three things from Chinese policy makers. Number one, they took up big monetary policy easing. Number two, they announced a package to support the equity markets. And number three, they announced some measures to support the property market.

Now we think that these measures are a positive and particularly the property market measures will be helpful. But in terms of real impediment for China's reflation story, we think that the key need of the hour is to take up aggressive fiscal easing to boost consumption. Monetary policy easing is helpful, but it's not really the key impediment to the reflation path.

Seth Carpenter: All right, so if I wanted to see the glass as half full, I would say, look at this! Beijing policymakers have turned the corners. They're acknowledging that there's some policy impetus that needs to be put into place. But if I wanted to see the glass as half empty, I could take away from what you just said, that there just needs to be more, maybe fiscal stimulus to directly promote household spending.

Is that that fair?

Chetan Ahya: That's absolutely right. What's happening in China is that there has been a big structural adjustment in the property sector because now the total population is declining. And so therefore there is a big demand hole that is being left by the weakness in housing sector.

Ideally, what they should be doing, as I was mentioning earlier, [is] that they should be taking a big fiscal easing to support consumption spending. But so far what we've been seeing is that they've been trying to fill that demand hole with more supply in form of investment in manufacturing and infrastructure sector.

And unfortunately, that's been actually making the deflation challenge more complex. So going forward, we think that, you know, we should be watching out what they do in terms of fiscal stimulus. There was a comment in the Politburo statement that they will take up fiscal easing. We suspect that the timing of that fiscal policy announcement could be by end of this month alongside National People's Congress meeting. And so, what will be the size of fiscal stimulus will be important to watch as well.

Currently, we think it could be one to two trillion RMB. But in our work that we did in terms of what is the scale of fiscal stimulus that is needed to boost consumption, we estimate that it should be somewhere around a 10 trillion RMB spread over two years.

Seth Carpenter: Got it. Thanks, Chetan. Super helpful.

Gentlemen, I have to say, we might have to stop here for the day. But tomorrow, I want to get [to] another topic, which is to say, the upcoming US election. It's got huge implications for the macroeconomy in the US and around the world. And I think we’re going to have to touch on it. But for now, we'll end the conversation here.

And thank you, the listeners, for listening. If you enjoy this show, please leave us a review wherever you listen to the podcast and share Thoughts on the Market with a friend or colleague today.