Morgan Stanley: We Sense A Shift In Tone From The Fed

"Sunday Start" by Chetan Ahya, Morgan Stanley chief economist and global head of economics

The Bar Is Still High

Volatility remains elevated, and concerns about the health of the global economy have re-emerged. Persistent volatility and its impact on tightening financial conditions tend to focus markets’ attention on the central banks. Investors go on high alert, parsing for signs of a change in rhetoric and any indications that central banks may try to soothe the markets’ anxieties.

The latest message from the Fed. This past week, we heard from both the Chair and Vice-Chair of the Fed, which is central to this dynamic. We think they’ve sent a consistent message: The Fed is data-dependent, but with the economy doing as well as it is today, it still anticipates a gradual hiking path. While the bar for changing course remains high, we sense a subtle shift in tone relative to a few weeks ago, putting more emphasis on data dependence and signaling some flexibility on policy management after reaching neutral.

The bar is still high because the trade-offs are different today. Consider the current economic backdrop. US growth has been running above trend for a while; the unemployment rate has been running below its natural rate for the past 20 months; wage growth has accelerated, reaching a post-crisis high of 3.1%Y; core PCE inflation has stayed at target for a couple of months; private non-residential investment growth momentum has averaged ~6%Y for seven quarters; and productivity growth has picked up in the last two quarters. Households are saving more of their income (6.2%, to be precise) than in 2006-07, and household debt-to-disposable income ratios have remained low and stable. With both the strength and character of this economic expansion looking this good, it would be hard to build a fundamental case that the Fed needs to change course quickly.

But should the Fed worry about international developments? On the surface, recent growth data have weakened in Germany and Japan, while there are lingering concerns about the outlook for China and emerging markets in general. However, for Germany and Japan, the outright contraction in economic activity in 3Q was largely due to one-off factors – the imposition of new emission standards impacting car production in Germany and natural disasters in Japan. Moreover, survey data in both of these economies are indicating that activity probably picked up in October, suggesting that the impact is temporary. As for China, the defensive easing measures should help to stabilize growth in the next 1-2 quarters.

Global growth backdrop to remain supportive... In aggregate, global growth, on our estimates, did decelerate to 3.4%Q in 3Q18 from a very strong 4.1%Q in 2Q, but we estimate that it will move back above trend to 3.6%Q in 4Q18. The fading of temporary disruptions to growth in Germany and Japan, still-healthy momentum in global trade and a sustained recovery in emerging markets ex China should all lend continuing support to global growth.

…keeping the Fed on course towards neutral. Given the Fed’s domestic directive, we think that it will only be reactive to international developments to the extent they affect the US economic outlook, and won’t conduct policy in a way that pre-empts them. With the global economy expected to grow around trend, our chief US economist Ellen Zentner expects the Fed to keep hiking interest rates until it believes it has reached neutral territory, and pause then. In her view, that will happen around the middle of next year, following three more hikes in December, March and June.

As central banks stay on a tightening path, the ride will likely be bumpy. Asset markets will hit pockets of stress from time to time, with the latest episode unfolding in US credit markets. Our strategists remain cautious and think that the weakness in credit will continue. In sum, we think that asset markets must leave the warm embrace of the abundant liquidity central banks have provided since the global financial crisis. Like it or not, volatility is here to stay.