Kevin Warsh's failure to communicate. Plus: Europe's wildfires

(soft music) - It's Friday the 31st of July. This is your Capital Economics Weekly briefing. I'm David Wilder coming up, Europe's wildfires, there are human and environmental catastrophe, but what about the economic costs? But first, group chief economist Neil Shearing is with me to tackle the week's big issues in global macro, honeyle. - Hi David. I don't want to rehash stuff that we've spoken about already on the podcast, although invariably we do, given these do the themes that keep coming up. But a couple of weeks ago, we spoke on one of these episodes about whether Fed Chair Kevin Warsh was trying to torque markets into tightening. So trying to tighten financial conditions verbally, rather than through rate hikes. So talking the torque, but maybe not walking the walk. And holy cow, it is something that we do need to rehash, right? Yes, the Fed meeting over the past week, significant not for the outcome in terms of interest rates, which I don't think despite the market pricing and some charts of the rate hike was ever really endowed. It was really significant for the absence of any communication in the run up to the meeting. And then as you say, holy cow, absolute muddled communications after the meeting from Warsh in that press conference. And I think perhaps if you step back, take a look at the market reaction in the wake of the meeting. We saw a relatively unusual response in markets, which was lower rates at the short end, higher rates at the longer end, which implies a more dubbish fed in the short term, but greater inflation concerns in the long term. So certainly not the response you would want if you're a Fed Chair looking to burn a short inflation fighting credentials. There's a lot to unpack here, but the basic message that came across is that as you say, here is a Fed Chair who has repeatedly said that inflation has been overshooting the target, and we can talk about the target for five years now. He is not going to tolerate that. His colleagues on the FOMC are not going to tolerate that. But then he didn't give anything away in terms of exactly how they're going to get inflation back to target. In the end, so I think that's one issue that he's outlined the problem, but not necessarily given a sense of how he thinks the Fed should respond. But I think also, in addition, laid on top of this, there's been two other developments. The first is that he's also started the cat cast status to what the correct measure of inflation should be. So I think the exact words were something like PC. He's focused on PC, inflation for now, and that there will other alternative measures of inflation that might be slightly lower, might suggest underlying inflation pressures not quite as strong as the PC measure. Of course, we had that data this week showing something more modest month to month increase in PC inflation, but the annual core PC, inflation number is still well about 3% year on year. So the first thing is he's hinted that it might not just be PCE that he's looking at. There were wide measures of inflation, and they might be softer, which hence opens the door to perhaps a more dovish Fed. And then we had a really strange exchange in which more starts to talk about markets and the response to markets. And the fact that since he's become Fed Chair, we've seen high, phenomenal and real yields that in his words suggest that the markets, and now playing the ball, i.e. the economic data, not the referee, i.e. the Fed, which let's unpack that, but it seems to be a pretty torture analogy, really. And one that gets it wrong, the Fed's not the referee here. It sets the rules of the game. It's setting interest rates, and that's what the markets are trying to interpret, and second guess, if you like. So it was really the exchange where he started to talk about markets and the role of markets in helping to determine financial conditions and monetary conditions and responding to the Fed that was really confusing. And I think that has set hairs running in amongst investors. There's this idea going around that, you know, that Walsh knew exactly what he was doing in that press conference. And that the goal is maybe to wean markets off of forward guidance, sacrifice some near-term stability to reach this goal of longer-term price stability. What do you make of that argument? Well, I don't buy it, it's the short point. It always feels to me the last refugee of the desperate to say that you don't really get what's going on here. He's smarter than you. He's playing for the church, and you just don't simply don't understand what's happening. So mechos here of the defense that was given in the wake of the Liberation Day tariffs, Trump is playing for the chess again, and we were too dumb to really understand what's going on. And Dera said also the war with Iran. So I don't buy that defense, not least because if that was the case, then I think it would be relatively simple to do. You would just say, you can defend the idea of giving less forward guidance to markets and saying that you're going to be a bit more data dependent, but that your focus is on bringing inflation back to target. Without giving these muddled messages about balls of referees and different inflation measures and different roles AI might be inflationary or disinflationary, it's the muddle and confusion that surrounds it. So my sense is that it's not that warship's operating on another level, smart, though he undoubtedly is. It's just a classic case of a kind of cock up when it comes to central bank communications. Perhaps he's trying to be a bit too smart. But he won't be the first central banker that's made a bit of a hash of central bank communications. It's a difficult job. Christine, the guys had a struggle in the past before her John Claude Tricer had problems with communicating to markets too. So difficult job, my sense is that this is just, perhaps he's trying to be a bit too smart, perhaps as the message has got muddled, but I don't think it's the case that he's necessarily operating on a kind of higher plane than everyone else. So in terms of this question of forward guidance, do you expect, presumably it sounds like you're expecting his communications strategy to shift that we won't see your repeat of what we saw on Wednesday? As I bring you back to the market response, it's a pretty unusual one that the dropping yields at the short end of the curve, the rise in yields at the long end of the curve. If we look at FOMC meetings over the past three or four decades, there's really only a handful of meetings in which we've seen that combination happen. And as I say, it's a pretty unedifying one for central bankers because it implies a more dovish Fed in the short term and a greater inflation risk in the long term. So it's exactly what you don't want to see if you're a Fed chair. So I think for that reason alone, one have to see him sharpen up his game when it comes to communications. There's a separate question, I think, about forward guidance, the role that forward guidance can then should play in monetary policy. And I think, again, that's polarized opinions in markets and amongst economists. The truth is ever, I think, lies somewhere in the middle. And one of the points that this misses is that forward guidance is a bit like financial oppression. It isn't just a thing that happens. It exists on a spectrum. There's kind of relatively soft forms of forward guidance and very strong forms of forward guidance. For example, when the Bank of England in 2013 said that it wasn't going to raise interest rates until unemployment dropped below 7%. That was a pretty strong form of forward guidance. You have softer forms of forward guidance, too, where the central bank's tried to nudge markets one way or another. And there's a role for forward guidance, but I don't think it's quite the kind of silver bullet that some of its defenders make out. Nor do I think it's the massive challenge and problem that the war schencers it to be. OK, so what happens between, you know, come the September meeting. Obviously we've got some critical data releases between us now and then employment reports. We've got more inflation reports. You mentioned that, that income and spending that, that PCE inflation data out earlier this week. We've also, and we haven't mentioned this, but we're also presumably going to have his committee members on the FOMC giving their views to the market on what should be happening with rates as well. So how is it going to play, but come September, do you think? There's an awful lot, I think, to unpack there. The first point, as you say, we've not talked about at other FOMC members. All the focus has been on wash, but of course, he's one voice in 19 on the committee and an important voice, but only one of 19 and one of 12 that votes. And three of those 12 voting members actually voted for a hike this week's FOMC meeting. Although wash seems to be equivocating and sending muddled messages and mixed messages, other FOMC participants are not waiting around. They're voting for rate hikes. I think that reflects the fact that, yes, we've seen some softer headline inflation data. And indeed, the core PCE number in month or month terms in, in June was pretty soft and was car target-consistent, but that annual rate still above 3% year on year. And we've had data over the past week too that shows that the US consumer in particular is in pretty good health and pretty rude health. So GDP a bit softer than expected, but the consumption number is strong. And then when we look at the real spending numbers in the back end of Q2, so for May and then for June, we've just had the data, 0.4% month on month growth in spending. So some pretty strong numbers there. The Atlanta Fed GDP now cast for what it's worth is pointing to growth of almost 5% Q and Q analyzed in Q3. So my sense is that despite water's slightly mixed messages, muddle message messages, the incoming data is not quite as soft or dove issues that the recent run of soft through inflation data might suggest underlying inflation pressure is still pretty strong. And the real economy doing pretty well, consumers in particular doing pretty well. And of course, we've not talked about Iran, the oil prices back in the high 80s. If that remains the case going into September's FOMC meeting, then I think a hike still in play. Is there a chance perhaps that a September rate hike becomes even more likely if there is this sense in the market that the fed credibility is on the line? Perhaps that inflation expectations become looser? And the FOMC is going to have to double down to prove its inflation fighting credentials. Yes, I think possibly. I don't think we're there yet. But I think everyone should be keeping an eye on the long end of the code. Because if that continues to head higher and if that continues to reflect growing an ease about the long term inflation outlook, then at some point the fed will have to respond. So yes, you're right. The immediate response in markets, I wouldn't want to overplay this point, but the immediate response in markets, if that continues and particularly the long end goes up, then at some point the fed may have to step in. And that adds to the reasons to think that a September hike could be in play. Just last question on Warsh. I don't want to overstate it, but there is a slightly conspiratorial line that he was hired by the president on the understanding that he was going to cut interest rates, not raise them. And so that's why he's been trying to talk the talk to talk financial conditions into tightening rather than actually trying to push through rate hikes. So that he's following the letter, if not the spirit of some closed-door agreement with Trump. What do you make of that? Yes, the idea here is that if you. You're talking away that pushes the long end up, that tightens financial conditions and monitoring conditions, such that you think in a way that you think is necessary, but also means that you don't then have to follow out a rate hike set that would otherwise irritate the person that put you in the job. I have to say, again, it's pretty conspiratorial. I don't buy it for a couple of reasons. The first is that it's not obvious to me that financial conditions have tightened enormously, post-FOMC. The second is that in the past, Warsh has talked about financial conditions, particularly in the housing market, being too tight and not being reflected in weak levels of activity in the housing market. Well, if your objective is to tighten financial conditions, but by talking loose on inflation, you push that long end of the curve. Well, frankly, that doesn't help the financial conditions in the housing markets. It also means that you're likely to see an increased inflation expectation. So in real terms, financial conditions don't tighten. And most importantly, your markets are not stupid. The way this really should work, if you want the markets to do the tightening without you having to do the tightening, is that you have to talk tough on inflation, push up rates across the curve, that in a meaningful way, and that leads to tightening in financial conditions, but of course, if you don't then deliver that tightening in monetary policy, then markets will unwind that tightening. So this is a play on the so-called Maradona Theory of Central Banking, which I won't bore listeners with now, but we shall arise about on my notes on Monday. I was wondering when you were going to mention Maradona. I just want to finish last question, totally off topic. But before you go on to get your take on a debate that's been going on on social media this past week around global imbalances, the heart of this debate is a piece that was in the economist recently called Don't Blame Global Imbalances on the Undervalued Yuan. Basically, it says adjusting the exchange rate, the revenue be exchange rate, won't fix China's current account surplus. It kicked off a big storm on social media. I say a storm, but it's really a bunch of economists being economists. I don't really want to get into the weeds on this, not least because you're preparing a whole raft of analysis about global imbalances, about China's role in them, just mechanisms like exchange rates after the summer. But just very quickly give us a flavor of which side we're on on this particular question of whether a stronger Reminbee would fix China's surplus. Well, I think the first point to say is that although this might seem on the face of it, a case of have three economists and get four views. I don't, this isn't just academics being academics. This has a real world implications, and we'll kind of bring some of those implications and consequences out in the work that we're going to be publishing over the autumn. But the so-called China Shock 2.0, the second big wave of Chinese exports that's hitting the global economy, is having real life and real world consequences. Look at what's happening, particularly in the European car industry, and other areas of manufacturing in Europe. Now, having said all that to bring this back to academia, the exam question is what's the most effective way of reducing China's enormous current accounts and trade surplus? And in particular, what role can exchange rates play in all of this? I didn't mean as any doubt, by the way, that the real exchange rate in China is undervalued. The question really is the causes of that. Is it kind of suppression of the normal exchange rate or domestic inflation? And also, if you were to bring about a marked real appreciation of the RMIMB, what role would that have, or how effective would that be in reducing China's enormous trade surplus? On one side of the argument, that there's a bunch of academics and think tankers, like Brad Setzer, that argue that the currency is the place to start, the article that you mentioned that's among others has been written by XIMF officials in the economy suggests that the currency might have a more minor role to play. My take, our take, is that a stronger real RMIMB is a necessary but not sufficient condition to reduce China's current account surplus. I think in order to bring China's current account surplus down on a sustainable basis, there also needs to be a big shifted domestic policy in a way that reduces savings. Also, by the way, in order to reduce global imbalances, there needs to be a corresponding tightening of US fiscal policy too. Otherwise, what happens is you get reduction in Chinese savings and an expansion of Chinese consumption without the offsetting fiscal retrenchment in the US means that agglomely is stronger and you get a global inflation problem. But leave the fiscal retrenchment in the US to one side. The key point here is that a stronger real exchange rate in China alone is not going to necessarily bring down China's surplus on a sustainable basis. There's also a political economy point here too, though, which is that I think we can debate the role of the exchange rate as opposed to other structural reforms in China as a means to reduce the current account surplus. But the point is that the moment neither to me look like they're particularly likely to happen because Beijing, frankly, just doesn't see this as an issue. It doesn't necessarily view their RMIMB as enormously undervalued into the extent it is. It thinks it's the rest of the world's problem not China. And it certainly doesn't think that China's enormous current account surplus is a problem either for China and perhaps not for the rest of the world either. To some extent, we're kind of arguing about ourselves because the policymakers that really matter system Beijing, and I think there's next to no chance of a meaningful change in direction over the next couple of years. Neil Shearing on a frankly confusing Fed press conference and China's exchange rate. On the former, look out for Neil's note on Monday, which is going to go into more detail on the role at Ford guidance plays in monetary policy transmission. And on the latter, as we said, much more to come from the capital economics team on this huge and complex issue of global imbalances. As a Taster, I'll add a note about this Chinese exchange rate issue from Mark Williams, our chief Asia economist in the podcast notes. If you're not already getting our coverage and you want the analysis, the data, the access to economists, head over to our platform capitaleconomics.com, register your details, and you can start a trial of our coverage today. Now, headlines have been dominated these past couple of weeks by the devastating fires occurring in Southern Europe. We've seen the footage, the images, we've read the horror stories from those affected, but what do these fires mean on a macroeconomic level? Understandably, it's been a key talking point between clients and our Europe team. To find out more, I spoke to Chief Europe economist Andrew Kenningham, and I started by asking him how much of an economic hit these fires are. Yeah, well, I think it's one of those issues on which economists have to be careful not to sound too heartless, because clearly it is a very serious problem and it's been very damaging for some regions and for many businesses and people have been evacuated from their homes and so on. But I mean, I think it's our job to put it in context and think about it relative to the size of the whole economy, given that we're macroeconomists. I think on that basis, it really, I think we'll see a small reduction in regional GDP in areas like, for example, the Gerond in France, which is just about 2% of GDP in the older France. It won't really show up, I suspect, on the GDP numbers. Part of just for that reason. That's the key point, isn't it, that the areas affected by the. these fires are on a relative basis, not economically critical to the broad or the aggregate economies that are where the fires are occurring. Yeah, exactly. So the share of the economy, which is affected is small partly because just the regions are small, but also of course the fires tend to be in rural areas where the main activity, economic activities going on are agriculture, forestry itself, in some cases tourism, which is clearly an issue in France at the moment, but those sectors in general are relatively small. Now, there have been incidents in the past where more important industries or larger industries have been hit. So in the Canada, for example, oil production is sometimes being closed because of wildfires. And so there is always that risk, but in general, this is not something that tends to happen. So if you compare it to other sort of big exogenous shocks that affect the economy, these are more localised and less likely to result in big falls in GDP. In terms of recovering from these fires, the rebuilding process, what's the economic impact of that? Yeah, so both governments in Spain and France have pledged support, not surprisingly, for the regions affected. But if you look at the amount that they have been talking about, it's in the tens of millions of euros at present. Of course, it may scale up, you know, we may well see more damage in the coming weeks, and there's a further heat wave predicted to start very soon, but still we're probably talking in tens, maybe hundreds of millions of euros, which again, is not going to even be sort of a 1.1% of GDP. So if you're thinking about the overall fiscal position, the relatively good GDP numbers in Q2 are probably more important than the impact of the fires. And it does help that quite a lot of the damage will be covered by private insurance. So there will be insurance payouts clearly to the to landowners and to people whose businesses have been affected, which will help. You also get these sort of slightly paradoxical effects on GDP after natural disasters, where the spending on recovery will cause GDP or can cause GDP to increase. There's more money pumped into an area, whereas the damage which has occurred because of the the natural disaster itself doesn't actually get recorded in GDP. It's a stock that's affected, so land is damaged. That doesn't get into the GDP numbers. So obviously that's not to say it doesn't matter. We're calling this there often rightly accused of being overly obsessed by GDP. I mean, it's more a critique of GDP as a measure of welfare, but it is the case that you could get some some positives from recovery spending. It kind of gets me onto the sort of the longer term question here, because so the core message from climate scientists is get used to this, right? If it gets used to this, if not if not worse, it's going to be coming. When we think about Europe on a macro level, how do you gauge the longer term economic impact of global warming, rising temperatures? And by that, I mean, there's the sad likelihood that we're going to get more disasters like this summer's fires, but then to your point there that maybe there's this need to upgrade infrastructure industry, housing, transport, but also the structural shifts in things like tourism as well. So how do you capture the longer term impact on Europe's economy? I think it is complicated and we don't know a lot of the answers to how things will evolve, and so should acknowledge that to start with. In particular, we don't know how quickly the climate will change and how frequent and how bad these sorts of events will be, but our sort of base assumption, and I think it's quite widely held for you among economists looking at this, is that countries which the countries which were faced the biggest challenges of climate change are those where there's very large agricultural sectors and where the agriculture itself is going to face challenges and may struggle to continue at least in its current form. A developed economy is like Western Europe, and you see that agriculture is sort of around 2% of the economy, it's really quite small. That's the one that's going to have to do the most adaptation and we will certainly and already seeing shifts in the kinds of crops that are grown in different regions that may create problems for agriculture, certainly be transitional problems, but the macro scale is likely to be small, and also in many cases, ultimately there's no reason to think that there will be a lower level of output in future if the climate has changed and people are producing more widely in southern England and less in border or whatever it is, or tourism might shift equally from, I think we're seeing this already in the data, that's some shift towards tourism in the off season and in areas which are less prone to extreme heat waves. So there's a lot of adaptation that happens which doesn't necessarily reduce GDP, it just changes GDP. And as you said, there's also potentially a lot of spending on prevention of various kinds. I mean some of it will be more about behavior change, and I was in Paris last week and you can see even in Paris a long way from the wildfires, there are posters up everywhere campaigning for people not to throw their cigarette ends out of the window, it's clearly that's one of the potential causes of these fires, that's that sort of thing, but also more spending on and thinking about how you manage forests, you know, there could be more use of these so-called green fire breaks which they have in China as a leader in this, where they have these less flammable vegetation among the forests to try to sort of prevent them spreading too quickly. So there's a whole range of things that could happen as well as you know, there'll be a lot of evolution in the insurance industry as well, potentially with some insurance markets not functioning well, but on the whole it's more likely that they will provide more insurance for for the sorts of disasters that are becoming more common. But you know, the big picture is we don't think climate change is necessarily going to cause GDP growth to be lower on our origins in the future than it would otherwise have been. Andrew Kellingham on Europe's fires and the long-term impact of climate change on the region's economies. I'll add his analysis about the fires to the podcast notes. Again, if you're not yet a capital economics client, you can start a trial today on our website capitaleconomics.com. But that's it for this week. We will be back next week with more for the world of macro and markets. Until then, goodbye.