The Fed, the World, and China Shock 2.0

It's Thursday 17th September and this is your capsule economics weekly briefing. My name's Neil Shearing and we start this week with Big News, David Wilder, who has been leading this podcast, hosting this podcast for the past five years or so, has moved on. We're really sorry to see David go and his success is going to be in place in the next couple of weeks. But for the time being, the bad news is that I'm in the hot seat. The good news, though, is that I'm joined by Jennifer McEwen, our chief global economist to rake through what's been another big week in macro and markets. Hi, Jenny. Hi, Neil. The place to start has to be central banks. We're talking on Thursday afternoon London time, so we've not had the BOJ meeting, but we have had the bank of England, we've had the Fed last week, of course, we had the ECB. And I guess the big news in all of that is I will get into some of these messages, central banks sounding quite hawkish, the Fed, of course, hiking in the face of political pressure from the White House not to do so. So let's step back from the kind of day-to-day ebb and flow of monetary policy. Does that do you think put to bed any concerns about political interference on the Fed? Obviously we had this big push from the White House to cut interest rates when the idea that more should be cutting rates when he came into the Fed chairmanship. Do you think that puts all that political pressure and concerns about Fed independence to bed? I think it's certainly somewhat reassuring, clearly the Fed even underwashed will hike when needed, and there was obviously some doubt about that previously, particularly given the comments that he made just a month or two ago. I think what hasn't changed, though, is the concern about transparency, which I think Markets worries about the Fed surrounded two different areas, one that it might be subject to political interference, and I think to some extent at least, and that should now have eased, given that it's hiking, but the other, that there was going to be a significant loss of transparency underwashed, and I don't think that has changed a great deal. Yes, communications were clear at this time. Wars did set out that the Fed valued its independence, and it would continue to act independently, but he's still not setting out his projections for interest rates in the way that Fed members ordinarily would do, so that does mean that that uncertainty is still there about just what he's going to do and about what the plan is. Class, of course, we've had comments from Trump, and other members of the US administration, again, speaking out against the rate high, suggesting the interest rate should be as low as 1% in the US. So what's also clear is that that political pressure is going to persist? Yes, it feels to me like there were at least three kind of overlapping questions around the warship Fed. Wasn't there? One was, was it going to succumb to political pressure to lower interest rates? The second is this question around forward guidance, jettisoning forward guidance, is that a bad idea or is it okay? And the third is, what is the policy framework? What's the framework for thinking by the Fed? How will they react to shocks and how will they communicate those? It feels to me like the concerns in the first two, and the first two were a bit overdone. We never really bought the idea that the Fed would succumb to political pressure to cut interest rates, likewise, I don't think in an era when the global financial crisis has passed, there's no real need for, I think, lots of forward guidance. Is that your right? So transparency around policy and the transparency, particularly around the Fed's thinking and how they'll react to, in the case of different shocks and events that's still missing. And that's what I think Mark is going to be looking for for over the coming months and quarters. Let's return to those central bank meetings, though. So we've had, last week we had the ECB, they hiked, obviously, then this week we've had the Fed. They've hiked, too. The Bank of England didn't hike, but it's signalled that it was on the cusp of hiking at Will Heights are coming, and indeed we've penciled two hikes into our forecast now. The Bank of Japan, due to meet on Friday morning, Japan time, we expect hikes there, too. So is it the case that all these major development market central banks are just moving in the same direction? Well, yeah, as you've just said out, they clearly are at the moment. And I think that's unsurprising in the presence of an external shock. Now, as he said, until quite briefly, we hadn't really anticipated that the Bank of England would be hiking. But I think the longer this shock persists, the more it becomes clear that central banks are going to have to react and given that they're all experiencing significant increases in inflation, they're all being hit by higher energy prices in a similar way, it's not that surprising that in the near term, at least, they respond in a similar way. But the way that they've set these changes out is really quite different. And if you read into what they've said, I think the difference is in their economies is quite apparent in their comments. It's clear from both the Bank of England's indications that it's likely to hike soon, the ECB's explanations of why it has height already, that they're very much focused on the energy shock and on what that's doing to headline inflation and on the risk that that might start to feed through to the rest of the economy that you might start to see indirect effects on broader inflation pressures, or even second round effects on wage growth, which would be much more worrying. But it's the risk of that that's causing them to act rather than at any actual evidence of that. For the Fed, though, it's not just about energy, it's about that the strength of the economy and other sources of inflation, including AI sources, the rising prices of AI goods, and the general strength of the economy, the health of the labour market. There are all sorts of reasons why, at the moment, the inflation outlook looks slightly concerning for the Fed and warrants rate-high x. So I think that's going to mean that once this energy shock passes, assuming that we don't get a renewed surge in energy prices, then these domestic considerations can come back for the fall and the Fed, the ECB and the Bank of England, will be in very different positions again. And when we look at our forecasts against what's priced into the markets, how do we differ? Is it the case that the market's broadly pricing rates correctly at the stage, or do you think that actually the profit rates are going to look very different in practice? No, there are some quite significant differences, actually, in future, between our interest rate forecasts, and those that the market seems to have priced in, just really reflecting those differences that I've just set out, yes, in the near-term, all central banks or major central banks are being driven by the same shock, but looking further ahead, they're going to be driven by quite different things. So whereas the UK, for example, markets assume that we're looking at about 100 basis points of high x in total to an end point of around 4.75%. We don't think that we'll get anywhere near that high, probably a rate of more like 4%, and what's more, we think the interest rates can come down next year once the weakness of the economy comes back to the fall, and the same applies to the ECB, albeit to a lesser extent. Let's just talk a little bit about second-round effects, so-called second-round effects, because that's what central banks have been talking about a lot this week. They're hiking in part to kind of head off the risk of second-round effects. This is the idea that once you get an energy-price shock or any surprise shock, the real risk is not the inflation that stems directly from that shock, but the fact that it alters wage inflation expectations and therefore broader wage and price-setting behaviour. And therefore, seaps into core inflation, underlying price pressures and underlying inflation, and becomes more persistent, and that's what they're really trying to head off, right? So how big a risk do you think that is at this stage? We've pushed back on the idea, I think, over the past six months, really, that this is a major risk, but it must be the case surely that the energy-price shock goes on greater the risk of some of these second-round effects. Yeah, absolutely. That's definitely the case. The longer you have energy prices, this high, the more that workers will try to push for some compensation for their higher costs from their employers and therefore the higher the risk that the wage growth starts to pick up. But I think that that's a low risk for the UK and the Eurozone. In both cases, labour markets are still pretty weak and weakening surveys of likely wage growth and recent evidence on wage negotiations suggest that if anything, wage growth is still coming down in the UK and the Eurozone. Unless energy prices rise sharply again, take another leg up, which is possible, I think that that is likely to remain the case. What we might see is some indirect impact on food inflation, on transport inflation over the coming months, which would mean that this inflation shock starts to broaden. That's fairly likely, but I think what's much less likely is that we go that step further into a pick up in wage growth, whereas for the US, and even without the energy shock, the labour market is looking pretty good, the economy is growing, AI is clearly boosting demand. So there are reasons to think that wage growth might pick up in the US even without this energy shock. So I think therefore there's a much bigger risk of second round effects, which the Fed needs to respond to. But let's step away from inflation and just rate central banks. And over the past week or so, we've launched this major new series of work on China shock 2.0, the second wave of exports from China that's hitting the global economy. Walk us through what's happened over the past week in terms of the publications, what we've put out, what's coming over the next week, what should clients be on the lookout for? Yeah, okay. Well, it's been quite exciting. We've been publishing a lot. We started out really by setting out the issue, China shock 2, what it is and the rights of work that we're going to be doing, and then we looked at this from China's angle, whether China's over investment is sustainable, whether it's likely to continue, whether we're going to see China continuing to make. inroads into global export markets, the answer to which was broadly yes. And then we looked in detail at where China's export gains have come, and that's been relatively broad. And then this week we moved on to the impacts of the China shock on other economies, so we looked at how China's exports have been affecting the Eurozone and the benefits of China's shock for SCM. Looking forwards, we're moving on to lots of other strands of this research, one on how China's role in the world has affected advanced economy inflation, another on the green transition, and how reliance on China might interplay with the speed of the green transition. And then we're going to be doing some more work on the Remming Bee and the Accent to which it is undervalued, so lots more to come. Thanks Jenny. That was Jennifer McEwan on all things inflation, interest rates, and central banks. All of our central bank analysis can be found on the central bank hub on our platform. I'll link to that in the show notes. Jenny was also talking about the China Shock 2.0 work that we've been doing. I'll include a link to that too in the show notes. As Jenny says, there's more to come on everything from the impacts on emerging economies and currency markets to the green transition. We're also going to be hosting events in Europe and Asia on China Shock 2.0 over the coming weeks. Sign up for those on our website. For now though, that's all for this week. Thank you for joining us and we'll speak to you again soon. Goodbye!