Plotting in the Open

Jay Powell steadied the Fed’s narrative last week, and with the “dot plot” still pointing to three cuts this year, the market was reassured. It seems the central bank has a relatively wide tolerance margin for accidents on the road to disinflation. This dovish message for this year was somewhat offset by an upward revision in the policy trajectory for the next two years and the longer run. This adds to the sense that the Fed believes the neutral rate has increased. This is reinforced by Powell’s point on the strength of the supply-side in the US, which allows disinflation to co-exist with a still very robust economy, an indication that potential growth has improved. The general impression that the global monetary stance is easing or about to ease was further fuelled by the Bank of England’s dovish message last week, together with the Swiss National Bank’s surprise cut.

Yet, beyond this convergence of central banks in the short term, we think there is a distinct risk of monetary and currency disorder as another trade war may be looming with the US presidential elections ahead. Even if they are not necessarily facing the same quantum of additional tariffs on their exports to the US, China and the Euro area may be tempted to allow their currencies to depreciate to maintain their competitiveness. This could be all the more tempting that spontaneously monetary policies could diverge from the Fed’s, as cyclical conditions in the US are stronger than in most of their key trade partners, and levying additional customs duties would in any case lift price pressure on American consumers. Even within NAFTA, tension could rise. The central bank of Mexico has already chosen to cut without waiting for the Fed, as capital inflows attracted by the perspectives of near shoring could excessively raise the already appreciating peso exchange rate. A succession of disorderly competitive devaluations could ensue across large swathes of the world economy, potentially intensifying support for even more protectionist measures,  both in the US and outside the US.