FX Daily: The IMF makes another controversial policy recommendation but this time it’s justified

17th June 2014

  • BoE’s David Miles said Tuesday that he would not be surprised if the MPC increased interest rates from their record low 0.5% level before the Fed began to tighten. He believed there was a clear chance rates could rise before spring 2015 and saw the UK economy as robust and resilient. (The Times)
  • A Chinese commercial bank official said the targeted reserve ratio cut will have a limited impact in terms of lowering financing costs for small companies as credit risks makes it hard for banks to cut loan rates for small companies. (China Securities Journal)
  • Bank of Chongqing has confirmed that its reserve ratio has been cut by 50bp to 17.5%, following China Merchants Bank, China Minsheng Bank, Industrial Bank and Bank of Ningbo who announced they were allowed to cut their reserve ratio. (Sina.com)
  • In the minutes of the RBA’s June 3rd board meeting, the Bank said it was unsure current low rates would offset the mining investment fall and the impact of the recent fiscal consolidation. The Bank maintained its view that the AUD was high by historical standards and labour market spare capacity would contain wages for some time. (rba.gov.au/)
  • US states are enticing businesses with lucrative tax credits taking over the reins from the Federal government, whose tax breaks expired last year. In an effort to increase growth and job an increasing number of states are offering refundable or transferable state tax credit, guaranteeing companies cash flow despite the size of its state tax bill. (WSJ)
  • Australia ANZ Roy Morgan Weekly Consumer Confidence rose to 103.2 on June 15th, up from 102.2.
  • Australia May New Motor Vehicle Sales rose 0.3% on the month, following an upwardly revised 0.1% gain in April.
  • China May Foreign Direct Investment declined 6.7% on the year, despite expectations for a 3.2% gain, The decline follows a 3.4% gain in April.
  • Japan Machine Tool Orders was confirmed at 24.1% in May, as expected.

If anyone was so complacent as to think that a -1.0% saar contraction in the US in Q1 was simply “weather effects”, the IMF’s report yesterday outlined exactly why the US economic giant is buckling. While the IMF admitted that a “meaningful rebound is now underway”, it was not enough to offset weak growth in the first quarter and led the Fund to downgrade their 2014 growth outlook to 2% from the 2.8% pencilled as recently as April. A struggling housing market, the comedown from an inventory boom and slower external demand are the other factors stalling US growth. While we can expect business to restock inventories into the summer leading to faster near-term growth, the outlook housing and exports is more uncertain.

More worrying was the downgrade to the US long-term potential output growth and the implicit admission that economic slack isn’t as significant as policymakers had hoped. The US long-term growth rate is now seen at just 2%, below the 3% historical average. The US long-term problems are two fold – slower productivity growth and lower labour force participation. The structural reforms required to correct these long-term problems include immigration reform, increased spending on education and infrastructure and tax reform, all of which are likely to get bogged down in bureaucracy on Capitol Hill. While the shale gas revolution may have improved the economy’s external balance, it won’t last long. The Fund forecast rising import growth as more than offsetting this positive factor in the medium term. The US is still battling its internal demons of overspending and a wider current account deficit means a weaker dollar for the long-term.

The most controversial aspect of the IMF’s US review was advising that the Fed Reserve had room at keep the Fed Funds rate at zero beyond current expectations for the first hike in mid-2015. The Fund didn’t see the economy reaching full employment until the end of 2017 and expected inflation to remain muted. Even if inflation did temporarily pick up, the IMF advised that the Fed, with its greater foresight, should look through these factors and keep rates low. This is quite a statement as we head into the June FOMC policy meeting. Another revelation to come out of the IMF was increasing concern over low levels of market volatility and the concern that this is the eye of the storm. The Fund saw risks that “even with a successful and well-communicated increase in interest rates” there could be “significant swings in market flows and prices” which could reach far beyond US borders, The IMF is worried tapering tantrum 2.0 is on the cards. There is a comic irony in the fact that last year policymakers scathed the US for the heightened volatility they unleashed on global markets and now they are complaining about a lack of volatility. The IMF prescribed more FOMC press conferences and a new quarterly monetary policy report in the thinking that introducing a bit of market volatility now would be better than a spike in volatility later.

The majority of hawks on the FOMC are not calling for earlier rate rises based on improved growth prospects, but on financial stability and inflation risks. The US economy is fundamentally weak and although many point to significant job creation, this has occurred after 6 years of meagre jobs growth and workers deserting the labour force. It will take many more months of above 200K job creation to bring discourage workers back to the labour force and find the long-term unemployed jobs. However the eerily quiet of low market volatility is unnerving several market participants and this may cause them to hike rates before the economy is ready. The recent increase in the PCE deflator is also narrowing the Fed’s breathing room for keeping policy loose and rising oil prices increase the risks. We maintain our baseline scenario that the Fed will hike in Q3 2015 not on increased growth prospects but compounding risks. This gives the USD crosses a lot of time to climb higher. Diverging monetary policy has been a key theme in EUR crosses but unfortunately for the ECB this won’t be true for the EURUSD cross, one of the key culprits behind imported deflation. We maintain our call for euro-dollar to return to $1.38 on a three month horizon and continue to gain thereafter.