What if the energy shock gets worse? And what to expect from a Warsh-led Fed?

It's Friday 24th of April and this is your capital economics weekly briefing. I'm David Wilde coming up, Kevin Wash waiting in the wings, is he going to shake things up at the Fed? But first, meals out, but I'm happy to say that Jennifer McHugh now Chief Global Economist and David Oxley, our Chief Climate and Commodities Economist are with me to run through another busy week in Global Macro and Markets. Hi Jenny, hi David. Hi. Hello. I thought what better than to end the week on a downer because frankly the straight of hormones is still closed. There's not much in the headlines to suggest Trump and the IRGC are about to come to agreement. Who knows but I do think it's worth asking how much worse things could get. We've mapped out these scenarios to clients about how this conflict is going to play out. We've been working off this baseline scenario. This assumption the war ends in a matter of weeks without much lasting damage, that oil prices fall back. The global economy basically shrugs this episode off. But there is this more adverse scenario. And with tomorrow marking the second month of this conflict, I thought we at least need to talk about it. So Jenny, I wanted to start with you just to ask where we are in terms of baseline versus adverse scenarios. I guess in terms of the political situation, clearly we're not heading towards the most benign scenario at the moment. Of course, we hope that there's ceasefire talks will ultimately work. The things are still incredibly uncertain. And if anything, we might be heading a bit more towards the adverse. We'd previously assumed that perhaps in our baseline scenario, the conflict would end by the end of April. So perhaps we're edging away from that. But that said, what is most important for our macroeconomic forecasts is the extent to which energy prices rise. And I'm sure David will be telling you more about that shortly. But what we've seen so far hasn't really been a particularly adverse scenario in terms of gas and oil prices. They are still roughly in line with our baseline scenario. So I think unless or until we start to see energy prices rising more sharply, then we're still fairly comfortable to stick with what we've set out as a baseline scenario for the economy. Yeah, David, let me ask you to do prices make sense where they are. There's this narrative isn't there? The cargo that was shipping before the straight was really closed had been cushioning the commodities markets. And this effect is now fading. The cargo's are arriving and being delivered. And so physical supply is tightening. What do you make of that narrative? Yeah, I think as ever, there was in the detail really. So a lot of focus has been on the as tends to be on the month contracts, futures contract prices, rich for rent through just the context of the time of recording this is just above $100, about $105 per barrel. But that's only part of the story. If you look at the cost of dated Brent, so the Brent that's available for delivery more quickly, that's the price of that is coming above $130 per barrel. So I think that's it. The dichotomy between a baseline and a bus scenario is useful for most macroeconomic sense. But if you look in beneath the servers of how this crisis is being felt differently across geographic regions, different products, oil products as well, I think we're certainly well down the line of very adverse scenario in the physical markets already. As to how things play out, I think that's right. If you're looking at the shape of the futures curves for oil, for crude oil, the fact that the cost of futures contracts free for five months along the futures curves in your market is in steep accredations lower than they are commonly. It shows that expectations have been baked into the market that things will get back to normal to some degree in the second half of the year. We had the release of a special edition of the normally quarterly Dallas Fed survey, the US, and yesterday, which gave us a window into what oil and gas executives in the US are thinking about how things are going to pan out. One of the interesting things there was about 40% of respondents suggested that flows through the street were going to get back to normal by August and 25% of respondents suggested above November. So obviously huge amount of uncertainty, but I think that kind of tallies with what we're seeing in the futures market, but there is intense physical tightness in the market at present, but it can be squared of the shape of the futures curve in that that is not expected to continue indefinitely. The risk is obviously as the crisis rolls on, if we don't see a resumption in flows that seems to be implicitly priced in, the physical nature, the physical shortages we're seeing that the intense pressure on physical prices will become more normal and that will drag the whole futures curve up. As we sort of highlighted the outset of this crisis, it all depends on how long this goes for and how extensive the disruption for the straight is. Nothing's really changed in that fun. If anything, we're still in limbo. Limbo's for a good way of describing it, we're not quite in this baseline, benign scenario, we're not quite in this more adverse world, but we're somewhere in between. But if that does happen, if we don't get resolution near term, does $150 oil stop looking more realistic than the sort of $100 where we are at the moment? I think so. I think if you're taking this lead from, as I mentioned earlier, the dated Brent price, Brent oil for instant delivery, that got to $140 per barrel a few weeks ago, coming out around $130 per barrel. If that's a symbol of the physical tightness, I think, yeah, something closer to $150, possibly even higher in the near term. That's certainly possible, and I think that's more indicative of what would happen if things don't get resolved. Another key moving part of thinking about how that would play out in your market is you extend to which those high prices lead to some degree of demand destruction. I think we're already starting to see that interestingly. So, as I mentioned earlier, the fact that the uprope pressure on oil prices has not been felt uniformly amongst oil products. We've already seen around $200 per barrel jet fuel. What we're seeing in response to that is increasing reports of airlines, trimming capacity to reduce demand effectively. That will be one factor that would push against any upward increase in oil prices and product prices. But certainly, I think the conditions in the physical market, when more of this goes on, they're going to become more normal. That's kind of a sign of what would happen if things don't resolve in line with what's kind of baked since of the fuchsia's curve. So that demand destruction you spoke about. This is where you get luft hands are canceling the $20,000 flights. Jenny, what does that mean? I'm translating that into global macro conditions that this worsening situation that may happen in energy markets and commodity markets. Yeah. That would obviously be much worse news for the global economy and particularly for the inflation outlook. Indeed, where a lot of the drag on the economy would stem from is from the sharper increase in inflation. Under the baseline scenario where there is a ceasefire, where energy prices ease back, the increases in inflation that we would anticipate are really quite manageable with it peaking in the UK, for example, about just under 4% compared to the 3.3% we were acting in March in the Eurozone. That peak might be somewhat lower at 3%. But in the adverse scenario, things really start to change. The kind of adverse scenarios for energy prices that David was just speaking about. In that case, in the US, the impacts are relatively limited, given that we would expect a more limited impact on natural gas prices. There in our adverse scenario, we would have headline inflation up at about 4% or perhaps a touch higher. So it's certainly not a comfortable position from the Fed's perspective, but another dramatic increase. For the Eurozone though, given a likely much sharper increase in natural gas prices, we would expect headline inflation up at about 6% and in that situation, I think the ECB would be very much inclined to hike interest rates. And in terms of growth, I mean central banks hiking rates to that degree, is that where we start having to brace for recession? Yes, I think that is probably right in the Eurozone case, where we would anticipate the economic effects to be that the most harsh because of that particularly sharp rise in inflation, we would expect annual GDP growth to dip close to zero. So perhaps one or two quarters of declining quarterly GDP, which would amount to a technical recession. So I think in that case, you are looking at probably a recessionary scenario for the US though, because of the more moderate impacts on inflation, you would also expect a more modest impact on GDP growth, wherein our adverse scenario, we have it below 2% in annual terms. So certainly a softening on the back of those increases in energy prices. Okay, so a softening, but this isn't like global economic disaster, are you talking about? Well, maybe softening was a bit softer, a weakening certainly, and from the Eurozone's perspective, this would be quite bad economic stagnation. globally, we would anticipate growth dipping just below 2%, so on a lot of definitions that would be recessionary territory. So I don't think we're looking at a severe recession, but of course it just depends on how far prices rise and to what extent central banks need to respond to that. When we're thinking about, inevitably you draw on historical examples, there's been a lot of talk about 2022, Russia's invasion of Ukraine and the response there in energy markets. Is short-shop, shark markets adjust, economies sort of adjust, but would that still look at under this adverse scenario, are there other historical examples to draw on? It's fair to compare the current scenario to 2022. It's our most recent evidence of how rising energy prices that affects the economy, but I think there are some really important differences between the situation now and the situation then. For a start, energy prices simply haven't risen as far so far. But if we're looking into an adverse scenario where perhaps that they might rise as far or almost as far as they did back then, I think you would still feel a bit more sanguine about the inflationary impacts and the implications felt for central banks for a few reasons. One is that the inflationary environment is better than it was then. Then we were coming out of intense COVID shortages, which had already caused inflation to rise sharply. Also the labour market is far less tight than it was back then. We had some severe labour shortages at that time, which meant that wage growth was very much prone to rise in response to even higher inflation. Another is that interest rates now policy interest rates are much higher than they were back then. So we're already in neutral to slightly restrictive territory, whereas in 2022, the starting point for monetary policy meant that it was very accommodative and it was stimulating activity, potentially stimulating in inflation. So it was important for central banks at that time to raise interest rates sharply. Of course, there have been many energy shocks which we can look back at, including the 1970s, to think about how economies might respond. But such comparisons are really difficult because the economies have just changed so much. Central banks are much more credible now. We hope that they know much better how to respond with these types of shocks. They've learnt from the experience of 2022 that it's quite important to respond cautiously but promptly. And labour markets are very, very different now. There is less indexation, for example, that means the wage growth doesn't rise mechanically in the same way in response to a rise in energy prices as it would have back then in the 1970s. So that limits the extent of the pass through to broader inflation measures to which central banks would have to respond. And once central banks have to respond in that way and hike rates aggressively, of course, you then get even more severe economic impacts. And I just to stress, we have this adverse scenario. It's not our core assumption of where we're heading. But as you say, we're kind of moving away from the more benign scenario that would help maybe a month or so ago. But as we've been talking, I mean, this past week, we've had a load of data out haven't we? Do any of those releases give us a sense one way or another about the economic impact of what's been happening? Yeah, it's a bit mixed so far really. We've, we're seeing the inflation impact come through clearly already. We have inflation data for March now. So applying to a period after the conflict began and we've seen US headline CPI, for example, rise from 2.4% to 3.3% Eurozone inflation up from 1.9% to 1.5% in March. And that's all about energy effects. So so we are seeing that that mechanical channel definitely come through in the economic data. What we've not seen so far is any significant impact on consumer spending, both US and UK retail sales growth. It was strong in March so that there wasn't an immediate impact on spending. However, we have seen really sharp declines in consumer confidence in the US and the Eurozone, which are, which are quite worrying. So I think whether we see this feed through into week spending just depends again how long this hit last, how far inflation rises and whether labour markets start to be hit by it. Jennifer McEun and David Oxley there on our adverse Iran conflict scenario. I will link to our global economic outlook that explains our baseline and adverse scenarios complete with a full set of forecasts across DMs, DMs and markets. But I'm just looking at headlines now saying second round of talks in Islamabad maybe happening tonight. Any breakthrough that gets the straight open would of course bring us closer to the macro and market assumptions in our more benign baseline view. We will be keeping clients up to date as those talks progress. All of our key analysis on the conflicts implications are on our dedicated Iran page. It's got stuff on what's happening in commodities markets, how economies are responding to high energy prices and much more besides. If you're not already getting capital economics written analysis access to our data tools invites to our regular online drop in sessions, our in-person events and all of the ways we help decision makers make sense of this brutally uncertain global economy, then do get in touch and we can set you up with a trial account so you can explore what we've got to offer. Send an email to [email protected] and we can get you started. Now there's a load of big central bank meetings in the coming week but the most notable is going to be the Federal reserves. It's not just because this is the biggest of them all but because it could well mark the last meeting for Jerome Powell as Fed Chair. His term officially ends on May 15th and a Senate nomination hearing was held this past week for Kevin Warsh. He's who Donald Trump picked after the president fell out with Powell who previously been chosen by Trump to lead the Fed back in 2017. I spoke to Stephen Brown, our chief North America economist about what to expect from this upcoming Fed meeting but also about what Kevin Warsh might bring to the Fed if he gets confirmed. Here's that conversation now and it starts with what to watch from this coming weeks meeting. I think the key message is that the wristly towards the Fed sounding a little bit more hawkish so I mean since it hasn't been that long since the past meeting but since then we did get much payrolls which were a lot stronger than most expected so over 170,000 gain. To some extent that's a rebound from temporary factors that weighed on hiring over the winter, not least from the very harsh winter weather but it does still leave the labour market given that we are in a plumber rate. It leaves the labour market looking in a better state than the Fed for last month whereas since then we've also had March's CPI data which all over the headline to a court by the surgeon oil prices. There were also some more concerning signs beneath the surface with our estimate pointing to another above target gain in the court PC deflator from March and again not just due to tariffs but also sticky services price, gross elsewhere and also a pickup in AI and software related prices. So the wrists have arguably tilted a bit more towards the upside wrist to inflation as opposed to the downside wrist to the labour market. How that could play out in the statement so in the last two minutes from the last two meetings we have heard there's a group within the meeting participants that wants to change the statement so that it acknowledges that the next interest rate decision could be either a cart or a hike. Now that group does seem to be skewed towards the hawkish regional Fed president so don't get to vote on the policy statement which is probably why we haven't seen that change made already so that is the key risk here but they could change the statement to acknowledge that the next move could be a hike. I mean it does feel unlikely still I think that can be still mostly those regional Fed presidents maybe it's got on that little bit larger but I don't think the Fed's going to really want to rescind a hawkish message just now given uncertainty over just how long the kind of conflict could last. What's the state of some to dovish case on the Fed? It could be extent there is any. Well it is still largely that the kind of Fed funds target range at three and a half to three four quarters percent is still above most estimates of neutral and although there's a lot of discussion about whether the policy rate is really restrictive given GDP growth until the fourth quarter release was quite strong. If we look at the most technical sectors such as housing it's clear that they could then sit from lower interest rates and although maybe downside concerns about the labour market have diminished they certainly haven't gone away altogether so just to speak obviously we had we had some high profile layoff announcements again including from meta and those will continue to kind of hold back hiring in the coming months. So that would be the kind of the dovish case but even so Christopher Waller also said earlier this week that he is kind of getting used to the idea that payrolls growth could just be a lot softer than we've been used to in the past and that isn't necessarily the recession signal it once was given that it was being company by much lower in migration now. So obviously we do need to look at we unemployment rate rather than necessarily hiring and given that drop back to 4.3% it's certainly not sending any kind of serious alarm bells at the moment. But I guess the key thing about this this meeting this April meeting is that it could well be Jerome Powell's last as Fed Chair, right? Waiting in the wings we've got Kevin Warsh. We had his Senate testimony this week. His nomination hearing your team picked up on a couple of very interesting bits from that. And appeared the one that I think you highlighted was his problem with core PC as the Fed's preferred inflation measure. What's wrong with core PC? Yeah, this is so core PC being PC inflation excluding food and energy. So the traditional kind of core metric. The the issue with that is that it can be affected by large moves in individual non-energy or food components, which don't necessarily have any relationship to the kind of underlying strength of the economy. So particularly in the US components such as health insurance or even other types of insurance or even financial services tied to strength of the equity market, they can and indeed are lifting core PC at the moment relative to core CPI inflation. But that doesn't really tell us about raw to underlying price pressures, which is obviously what Fed cares most about. Kevin Warsh has suggested that trimmed mean PC would be a better indicator. And to create that, may essentially use the entire PC basket, but exclude those items that have moved very sharply in price either up or down. And it is a common way of measuring core inflation in some other countries, notably Australia and Canada, the central bank there both prefer a trimmed mean measure of core inflation and a medium measure too. Now the big problem, well, there's kind of it was two issues at the moment. One is it kind of leaves wash open to criticism that he might be moving the goal post because trimmed mean PC inflation at the moment is quite a bit lower than core inflation. They're almost a 4% lower core PC. We estimate it was 3.2% in March. Trim mean was 2.3% in February. I think what we have done work on this just recently and it is the case, but core PC inflation is being propped up by kind of a handful of components that really don't tell us much about underlying demand pressures. So I think there is some logic to the idea that trim mean is probably the better indication of core inflation prices currently. The issue however is that trimmed mean inflation lagged considerably at the start of the kind of a post pandemic inflationary shock. So central banks, including the bank Canada, which has this trim mean measure already, that put weight on that ended up missing the start of the inflation shock party for that reason because these other measures didn't fully capture the price pressures coming through. So I think you wouldn't you wouldn't want to lean entirely on that measure, but I think it is valid to say that there are other measures of core inflation that certainly the what Fed should put some weight on. As you said, I mean the conspiracy theorist will say this is just a backdoor way for him to justify rate cuts, but core PC was adopted as the preferred inflation measure because 15, 20 years ago, the Fed became dissatisfied with CPI as the preferred measure. So it's not unusual to change what you're looking at to understand what's happening with price pressures within the economy. Yeah, and I think we should also stress that this is not a completely new measure that the Fed has never talked about before. The trim mean PC measure is included in its kind of biannual monetary policy report to Congress. So it is one they already look at it's just not given quite as much weight as it could begin. And then he was also talking in this testimony about broadening the spectrum of prices that the feed into how the Fed measures inflation. Does that fit into this idea of changing up your preferred inflation gauge? Yeah, this one seems like quite a strange one to me to be honest because the Fed, essentially one of the criticisms from the Trump administration that the Fed has got too large. The idea of doing a billion price projects that's not going to be easy or at least is going to require at least some labor resources right even in today's day of AI. And you could end up with a measure of inflation which looks completely different to the official measures that are still passed with targeting. So for instance true inflation is kind of a measure like this that's formed from prices that can be found online and often often gives completely different measure than the official measures. I guess yeah, it also does open warshop criticism that it could be trying to find ways to justify cutting interest rates even though the Fed's kind of traditional inflation measures are too high. But given how long it would take to set up these measures, that isn't probably isn't going to be some sort of moving policy for at least a couple years. We keep coming back to this idea that you know, war should be looking for ways to justify rate cards. I mean the bottom line is the reason why he was sat in that chair giving his testimony this past week is because the president has been very vocally dissatisfied with his previous Fed chair pick and the big issue here really isn't it is this insult frankly that he's a sock puppet Elizabeth Warren's words not mine who will do what Donald Trump wants in other words cut rates and cut rates a lot. Assuming he's in the chair assuming he gets the nod assuming that Trump and the Iranians have somehow come to an agreement that the oil prices head lower does that happen does the president get these rate cuts. We are still forecasting one final cut in the cycle will be will be a not until early 2027. I think you know at the end of the day, war is still only one vote on the 12th person committee. So there needs to be at least seven vote, six other votes in favor of cutting interest rates. And given the shift we kind of just talked about in terms of the downside to the labor market seemingly diminishing that the upside risk to inflation increasing a bit. It just doesn't seem like the F. C or at least a small-ish majority of them will be in place to support a rate cut for at least six months. I would say maybe they managed to sneak one in to the very end of this year but the reason we've gone with early 2027 is because that's how long it's going to take even if our fairly optimistic assumptions for kind of energy prices prove correct. It will take into early 2027 for those inflation metrics to be coming much closer towards 2% I guess. And I think given we are now talking about five years of inflation being about target the barrier to these additional rate cuts is certainly higher than it was late last year. That all implies that there will be more clashes between the White House and the third before this administration is through. Oh yeah, I think that's almost inevitable. I mean I guess maybe war should have a short honeymoon at least. I guess the benefit for wars is I mean the other thing we had in his testimony this week or his hearing is that wars is very much of the view that the Fed's independence is only in the area of setting monetary policy. He seems very willing to work with the administration in other areas such as bank deregulation where he could sort of carry some favor and hopefully deflect from the issue of potential interest rate cuts for a short while at least. As I said this could well be Jerome Powell's last meeting as Fed Chair. You mentioned trim means of failure to pick up the pandemic inflation shock. I mean that was if you're not Donald Trump that's the main criticism of Powell's tenure isn't it that they failed really they were they were treating inflation as transitory and there was this whole debate about what does transitory mean and basically they let inflation get out of hand and suddenly that's Worship's criticism of Powell's tenure. What do you think the current chair's legacy will be though? I think he's mostly made up for that mistake. I mean the Fed were although they were slow to react initially they then reacted extremely forcefully. There are many meetings where they you know hike by 50 base of points or more and for the most part managed to get inflation on the control right yes we haven't managed to get back to target yet but given the latest shock can hardly be blamed on the Fed I think Powell's going to get the blame for that either. And you know the I think the big point is that at the time we were in this group as well most forecasters expected a recession when the Fed started hiking so aggressively whereas the Fed in fact managed to secure that soft landing with with a recession avoided and we are on employment rate rising relatively modestly so I think his assessment of his tenure is going to be largely positive. And it must be said defending the credibility and independence of the Fed from from these extraordinary attacks from the White House. Yeah I mean I think he's done that very well he certainly showed a lot of personal restraint who knows maybe he'll go for a mic drop moment and in the final meeting next week but we could probably rule that one out. But yeah he's done a good job in that area I think that is obviously one area where Warsh is going to be probably quickly compared to Powell right in terms of you know perhaps he gets us a short honeymoon a few meetings from Trump but at some point Trump is probably going to the correct size than we again if we're right that the economic backfrog really isn't going to cool for much more in a way of interest very cuts. It remains to be seen how how Warsh will react you know maybe subconsciously or consciously this is one reason why Warsh would prefer that there were fewer FOMC meetings or maybe dropping some of the press conferences because that would reduce the frequency of the attacks that could be made. against him as well. But yeah, this is certainly one area where water is going to be under a lot of scrutiny in the coming months. Stephen Brown there on Jerome Powell's legacy Kevin Waters plans and why there could be a hawkish tilt from the Fed at the April meeting. We'll be holding our regular central bank drop-in on Thursday at 10 a.m. New York 3 o'clock London to answer questions about what came out of the Fed, ECB and Bank of England April meetings. I will add registration details to that short form online briefing to the podcast notes. But that's it for this week. We will be back next week with more from the world of macro and markets. Until then, goodbye.