Global Macro Views – Is there a Fed pivot?

Emerging markets have been in a severe sell-off since early June, when high CPI inflation in the US caused the Fed to accelerate its monetary policy tightening by hiking in 75 bps increments.

Last week signaled an end to that urgency, with Chair Powell saying that “We’re at 2.25 to 2.5 and that’s right in the range of what we think is neutral.” Markets rallied in response and emerging market currencies felt relief for the first time since early June.

However, Fed speakers have in recent days been pushing back on what perhaps is seen as too much market relief.

This Global Macro Views reviews the work we published in April on the controversial topic of R*, which is the academic term for the real neutral policy rate.

While elevated inflation signals that R* has risen from where it was pre-COVID, financial conditions have also tightened very substantially, with the tightening on par with the global financial crisis in 2008 and the 2020 COVID shock. Substantial tightening is therefore in the pipeline, which is why – against the backdrop of mounting global recession risk – we think the Fed’s signal of less urgency is the right path to take.

In last week’s Global Macro Views we tied the recent rise in the Dollar versus EM to the hawkish Fed pivot in June (Exhibit 1 – above). Last week’s FOMC meeting – by signaling that the Fed now thinks it is within the vicinity of “neutral” – dialed that hawkish pivot back, which saw most emerging markets rally (Exhibit 2).

But the underlying question – what is neutral – is a thorny one and the answer remains elusive. Chair Powell was presumably referring to the longer-run nominal neutral rate that the Fed publishes in its Statement of Economic Projections (Exhibit 3).

FED hiking

“That longer-run rate is an equilibrium concept, a neutral rate that obtains in the medium-term, when short-term cyclical distortions – like elevated inflation – have subsided. Indeed, our update of the Laubach-Williams R* estimate, which you can think of as more of a short-term neutral rate has risen from 0.0 percent before the pandemic to 3.2 percent now (Exhibit 4), driven up by elevated inflation.

“This is a real rate, which means that the nominal neutral rate is likely closer to 5 percent and perhaps higher if inflation has shifted to a permanently higher equilibrium rate.”

So, by this narrow definition, the Fed remains far below neutral. But narrow definitions don’t cut it in the real world, where lots of complexities exist that economic models cannot hope to incorporate. At the current juncture, markets price slightly more than a 50 bps hike in September and 25 bps hikes in November and December (Exhibit 5).

“We think that is sufficient hiking, especially since financial conditions have tightened so much more given the sharp rise in mortgage rates (Exhibit 6).”

“With global recession risk mounting rapidly, we think this is the right time for the Fed to set urgency aside and stick with 100 bps in hikes for the remainder of this tightening cycle.”