February 12, 2020
Jerome Powell just spent two days on Capitol Hill, making prepared remarks to Congress on the economy, and then painfully entertaining their questions/ monologues.
The message from Powell hasn't changed. The economy is good and inflation is tame, yet they stand ready to act against changes to that view.
What could change that view? The old risk to that view was an indefinite trade war. The new risk to that view is the unknown outcome of the coronavirus. But the former already forced the Fed and the ECB back into balance sheet expansion. And the latter has the central bank in China flooding China, and global markets, with liquidity.
If we think about the primary purpose of this liquidity deluge: It's to stabilize and/or restore confidence. Confidence is the key ingredient in keeping the economic engine going. Through low rates, balance sheet expansion, and credit creation, the Fed has proven over the past decade to be able to promote higher stock prices and higher housing prices. That has translated into hiring, spending and investing, which has translated into economic activity — all despite a myriad of threatening crises.
So, currently we have record high stocks, a strong housing market, and solid economic data. It appears that the central banks (led by the Fed) have again been successful in using the balance sheet to stabilize confidence (which was waning in the third quarter last year).
This should be a powerful line of defense against a reduction in global growth from the health crisis in China. Still, the market is pricing in more Fed rate cuts – a coin flips chance of at least one rate cut by July. And by the end of the year, the market is pricing in a near 80% chance of at least one cut – and plenty of bets are being place on several cuts.
This is either reflecting the view of the coronavirus turning into a global pandemic, which would be far too conservative in pricing in just a rate cut or two. Or it's reflecting a view that the U.S. economy isn't any better today, than it has been over the past decade. Both seem like very low probability scenarios (unsupported by the data).
What's clear is that the market is leaning heavily one way. If this health crisis threat were to clear in the coming weeks, the economy would be positioned for a big upside surprise in growth into the end of the year. This brings in the other side of what could change the Fed's view: hotter inflation. That's my bet.