Last year the US was exceptional in many ways. A large fiscal expansion accelerated growth while the world was slowing. Core inflation as measured by the personal consumption expenditures price index climbed up to the Federal Reserve’s 2 per cent target for the first time in more than six years, but remained stuck far below target in Europe and Japan.
As a consequence, the Federal Reserve confidently raised interest rates every quarter and shrank its balance sheet, while the European Central Bank and the Bank of Japan continued to conduct quantitative easing. With tax cuts boosting profits, US stocks outperformed most others and wider growth and interest rate differentials propelled the dollar higher, with adverse consequences for emerging markets.
This year, however, US exceptionalism looks set to fade on several fronts. For starters, the growth gap between the US and the rest should narrow significantly.
One reason is that US financial conditions have tightened significantly in recent months as the Fed continued to raise rates, credit spreads widened, the dollar appreciated and equities tanked. While the recent drop in bond yields could be seen as offsetting some of the tightening, it has also flattened the yield curve further, which is hardly encouraging.
Another reason to expect an ebbing of US growth momentum relative to the rest of the world is that fiscal stimulus will be fading in the course of this year and additional tax cuts or spending increases look unlikely in the new political constellation following the midterm elections. Meanwhile, more fiscal easing will be forthcoming in China and Japan, as well as in several European countries including France and Italy in response to slower growth and populist pressures.
Moreover, the plunge in oil prices since early October benefits the Chinese, European and Japanese economies more than the US economy as the former are large net energy importers whereas the US nowadays produces about as much energy as it consumes. Thus what US consumers gain from lower energy prices is roughly matched by losses for domestic producers. Also, as the example of the previous sharp drop in oil prices in 2014/15 demonstrated, producers may cut investment faster than consumers spend their windfall gains, so that the near-term net impact of lower oil prices on the US economy could in fact be negative.
With growth slowing, inflation still tame, markets more volatile, and interest rates reaching neutral territory, the Federal Reserve looks likely to pause or even end its tightening campaign sooner rather than later this year. Whether this happens already at the current level of the fed funds rate, which is what the money market forwards are currently pricing in, or after one or two more rate hikes will depend on economic data and financial market developments.
In any case, Jay Powell and his colleagues will be facing a formidable communication challenge whenever they decide to signal a pause. To see why, recall Ben Bernanke’s experience soon after becoming Fed chair in early 2006. When he first mentioned that the Fed might pause its rate hike cycle “at some point in the future”, markets immediately jumped to the conclusion that the Fed was done tightening and would start easing soon. When media then reported a few days later that he felt misinterpreted, markets corrected sharply. Eventually, the Fed didn’t “pause” but ended the rate hike cycle after two more increases.
Yet, whether, how and when to pause or end the rate hike cycle is not the only tricky decision Jay Powell and colleagues will be facing this year. The Committee will also have to decide on how to technically operate monetary policy in the future, which will determine the level of excess reserves required to run the system smoothly. If the Fed decides to stick to the current “floor” system, as seems likely, rather than return to the pre-crisis system, balance sheet shrinkage and thus quantitative tightening could come to an end in the second half of this year.
Will the fading of US growth and monetary policy exceptionalism spell the end of US equity outperformance and of the dollar rally? Not necessarily. US companies remain more profitable and cyclically sensitive stocks account for a smaller share of the overall market than in many other markets. Also, a pause in the Fed’s rate hike cycle and a potential end of quantitative tightening should help (relative) US equity performance. Meanwhile, a dollar reversal at some stage this year is entirely conceivable, but it requires two triggers: a trade deal between the US and China and a clear signal from the Fed that the end of the tightening cycle is near.
If so, the end of US exceptionalism would be good news for risk markets — and for President Trump.
The author is a managing director and global economic adviser at Pimco
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