Fed Timing Risks and Policy Considerations

Morgan Stanley’s chief economists have their quarterly roundtable discussion, focusing on the state of inflation across global regions, the possible effect of the US election on the economy and more.

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Seth Carpenter: Welcome to Thoughts On the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist. On this episode, on this special episode of the podcast, we'll hold our second roundtable discussion covering Morgan Stanley's global economic outlook as we look into the second quarter of 2024.

It's Thursday, March the 14th at 10 am in New York.

Jens Eisenschmidt: And it's 2 pm in London.

Chetan Ahya: And 10pm in Hong Kong.

Seth Carpenter: Excellent. So, things around the world have changed significantly since our roundtable last quarter. US growth is notably stronger with few signs of a substantial slowdown. Inflation is falling, but giving some hints that things could stay -- maybe -- hotter for longer.

In Europe, things are evolving mostly as anticipated, but energy prices are much lower, and some data suggest hope for a recovery. Meanwhile, in China, debt deflation risks are becoming a reality. And the last policy communication shows no sign of reflation. And finally, Japan continues to confirm the shift in equilibrium, and we are expecting the policy rate change imminently.

So, let's dig into these developments. I am joined by the leaders of the economics team in key regions. Ellen Zentner is our Chief US Economist, and she's here with me in New York. Chetan Ahya is our Chief Asia Economist, and Jens Eisenschmidt is our Chief Europe Economist.

Ellen, I'm going to start with you and the US. Have the stronger data fundamentally changed your view on the US economy or the Fed?

Ellen Zentner: So, coming off of 2023, growth was just stronger than expected. And so, carrying that into 2024, we have revised upward our GDP forecast from 1.6 per cent Q4 over Q4 to 1.8 per cent. So already we've got stronger growth this year. We have not changed our inflation forecast though; because this could be another year of stronger data coming from supply side normalization, and in particular the labor market -- where it's come amid higher productivity and decelerating inflation. So, I think we're in store for another year like that. And I would say if I add risks, it would be risk to the upside on growth.

Seth Carpenter: Okay, that makes sense. But if there's risk to the upside on growth -- surely there's some risk that the extra strength in growth, or even some of the slightly stronger inflation that we've seen, that all of that could persist; and the Fed could delay their first cut beyond the June meeting, which is what you've got penciled in for the first cut. So how do you think about the risks to the timing for the Fed?

Ellen Zentner: So, I think you've got a strong backdrop for growth. You've got relatively easy financial conditions. And Fed policymakers have noted that that could pose upside risks to the economy and to inflation. And so, they're very carefully parsing every data point that comes in. Chair Powell said they need a bit more confidence on inflation coming down. And so that means that the year over year rate on core PCE -- their preferred measure of inflation -- needs to continue to take down.

I think that the risk is more how long they stay on hold -- than if the next move is a hike, which investors have been very focused on. Do we get to that point? And so certainly if we don't see the next couple of months and further improvement, then I think it just does lead for a longer hold time for the Fed.

Seth Carpenter: All right. A risk of a longer hold time. Chetan, how do you think about that risk?

Chetan Ahya: That risk is important to consider. We recently published on the idea that Asian central banks will have to wait for the Fed. Even though inflation across Asia is settling back into target ranges, central banks appear to be concerned that real rate differentials versus US are negative and still widening, keeping Asian currencies relatively weak.

This backdrop means that central banks are still concerned about future upside to inflation and that it may not durably stay within the target. Finally, growth momentum in Asia excluding China has been holding up despite the move in higher real rates -- allowing central banks more room to be patient before cutting rates.

Seth Carpenter: I got it. Okay, so Jens, what about for the ECB? Does the same consideration apply if the Fed were to delay its cutting cycle?

Jens Eisenschmidt: I'm glad you're asking that question, Seth, because that's sort of the single most asked question by our clients. And the answer is, well, yes and no. In our baseline, first of all, to stress this, the ECB cuts before the Fed, if only by a week. So, we think the ECB will go on June 6th to be precise. And what we have heard, last Thursday from the ECB meeting exactly confirms that point. The ECB is set to go in June, barring a major catastrophe on growth or disappointments on inflation.

I think what is key if that effect cuts less than what Ellen expects currently; the ECB may also cut less later in the year than we expect.

So just to be precise, we think about a hundred basis points. And of course, that may be subject to downward revision if the Fed decides to go later. So, it's not an idle or phenomenon. It's rather a rather a matter of degree.

Seth Carpenter: Got it. Okay, so that's really helpful to put the, the Fed in the context of global central banks. But, Ellen, let me come back to you. If I'm going to look from here through the end of the year, I trip over the election. So, how are you thinking about what the US election means for the Fed and for the economy as a whole?

Ellen Zentner: Sure. So, I think the important thing to remember is that the Fed has a domestic directive. And so, if there is something impacting the outlook -- regardless, election, geopolitics, anything -- then it comes under their purview to support the economy. And so, you know, best example I can give maybe is the Bush Gore election, when we didn't know who was going to be president for more than two months.

And it had to go to the Supreme Court, and at that time, the uncertainty among households, among businesses on who will be the next president really created this air pocket in the economy. So that's sort of the best example I can give where an election was a bit disruptive, although the economy bounced back on the other side of that.

Seth Carpenter: But can I push you there? So, it sounds like what you're saying is it's not the election per se that the Fed cares about. the Fed's not entering into the political fray. It's more what the ramification of the election is for the economy. Is that a fair statement?

Ellen Zentner: Absolutely. Absolutely fair.

Chetan Ahya: One issue the election does force us to confront is the prospect of geopolitical tension, and in particular the fact that President Trump has discussed further tariffs. For China, it is worth considering the implications, given the current weakness.

Seth Carpenter:  That’s a really good point, Chetan, but before we even get there, maybe it's worth having you just give us a view on where things stand now in China. Is there hope of reflationary fiscal policy?

Chetan Ahya: Unfortunately, doesn’t seem like a lot right now. We have been highlighting that China needs to stimulate domestic demand with expansionary fiscal policy targeted towards boosting consumption. And it is in this context that we were closely watching policy announcement during the National People's Congress a couple of weeks ago.

Unfortunately, the announcement in NPC suggests that there are very limited reflationary policies being implemented right now. More importantly, the broad policy focus remains firmly on supporting investment and the supply side; and not enough on the consumption side. So, it does seem that we are far away from getting that required reflationary and rebalancing policies we think is needed to lift China back to moderate 2 to 3 per cent inflation trajectory.

Jens Eisenschmidt: I would jump in here and say that part of the ongoing weakness we see in Europe and in particularly Germany is tied to the slowdown in global trade and the weakness Chetan is talking about for China.

Seth Carpenter: Okay, Jens, if you're going to jump in, that's great. Could you just let us know where do you think things go in Europe then for the rest of this year and into next year?

Jens Eisenschmidt: So, we see indeed a small rebound. So, things are not looking great on numbers. But, you know, where we are coming from is close to recessionary territory; so everything that's up looks will look better.

So, we have 0. 5 on year and year growth rates; 1 percent next year; 0.5 for this year. In terms of quarterly profiles -- so, essentially we are hitting at some point later this year a velocity between 0.2 to 0.3, which is close to potential growth for the Euro area, which we estimate at 1.1.

Seth Carpenter: Got it. Okay, so outside of the U. S. then. China's week. Europe's lackluster Chetan, I gotta come back to you. Give us some good news. Talk to us about the outlook for Japan. We were early adopters of the Japan reflation story. What does it look like now?

Chetan Ahya: Well, the outlook in Japan is the exact opposite of China. We are constructive on Japan's macro-outlook, and we see Japan transitioning to a moderate but sustainable inflation and higher normal GDP growth environment.

Japan has already experienced one round of inflation and one round of wage growth. But to get to sustained inflation, we need to see wage growth to stay strong and more evidence of wage passing through to inflation. In this context, we are closely watching the next round of wage negotiations between the trade unions and the corporate sector.

We expect the outcome of first round of negotiations to be announced on March 15th, and we think that this will reflect a strong acceleration in wage growth in Japan. And that, we think, will allow Japan's core inflation to be sustained at 1.5 to 1.75 per cent going forward.

This rise in inflation will mean higher normal GDP growth and lower real interest rates, reviving the animal spirits and revitalize the corporate sector. We do see BOJ moving from negative rates to positive rates in March 19th policy meeting and later follow up with another 15 bps (basis points) hike in July policy meeting. But we think overall policy environment will remain accommodative supporting Japan's reflation story.

Seth Carpenter: All right, that does make me feel a little bit better about the global economy outside of the US. But I'm seeing the indication from the producers, we've got to wrap up. So, I'm going to go to each of you, rapid fire questions. Give me two quick risks to your forecast. Ellen for the US…

Ellen Zentner: All right. If we're wrong and the economy keeps growing faster, I think I would peg it on something like fiscal impulse, which has been difficult to get a handle on. Maybe throw in easier than expected financial conditions there that fuel the economy, fuel inflation. I think if we slow a lot more then it's likely because of some stresses in the banking sector.

Let's think about CRE; we say it's contained, maybe it's not contained. And then also if companies decide that they do need to reduce headcounts because economic growth is weaker, and so we lose that narrative of employee retention.

Seth Carpenter: Got it. Okay, Jens, you're up. Two risks.

Jens Eisenschmidt: The key upside risk is clearly consumption. We have a muted part for consumption; but consumption isn't really back to where it has been pre-COVID or just barely so. So, there's certainly more way up and we could be simply wrong because our outlook is too muted.

Downside, think of intensification of supply chain disruptions. Think about Red Sea. The news flow from there is not really encouraging. We have modeled this. We think so far so good. But if persists for longer or intensified, it could well be a downside risk because either inflation goes up and/or growth actually slows down.

Seth Carpenter: Perfect. All right, Chetan, let me end with you and specifically with China. If we are going to be wrong on China, what would that look like?

Chetan Ahya: We think there are two upside risks to our cautious view on China's macro-outlook. Number one, if global trade booms, that helps China to use its excess capacity and enables it to de-lever and lift its inflation. And number two, if we see a shift in the reflationary and rebalancing policies, such that there is aggressive increase in social expenditure on things like healthcare, education, and public housing. This would help households to unlock precautionary saving, boost consumption demand, and get China out of current deflationary environment.

Seth Carpenter: Got it. Ellen, Chetan, Jens, thank you each for joining us today. And to the listener, thank you for listening. If you enjoy the show, please leave us a review wherever you listen to the show and share thoughts on the market with a friend or a colleague today.