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2017 Outlook: Fed Hawks Take a Stand on Inflation

TOM BUTCHER: Natalia, how does the Federal Reserve’s (the “Fed”) December 14 decision to raise interest rates (0.25%) fit into the global monetary policy narrative?

NATALIA GURUSHINA: Even though the Fed was the only major central bank that not just hiked the policy rate but also actually indicated an accelerating base of tightening in 2017, other major central banks appear to be less willing to dig deeper into quantitative easing. They seem to want steeper yield curves, and more positive participation from the fiscal side. If you look at the data releases tied to labor markets, for example, which is now creating higher inflation expectations in many parts of the developed markets ― the euro zone, the U.S., and the U.K. ― this is giving central banks an excuse to start changing course. Given this general shift towards more hawkishness, we think there are risks that nominal yields will rise more, that curves will steepen more in developed markets. Also, given that there is a near-term policy divergence between the Fed and other central banks, there is definitely more room in our opinion for U.S. dollar strength.

BUTCHER: What can we surmise about the new administration, the Fed, and future rate hikes?

GURUSHINA: If you look at the latest forecasts, the Fed now expects three full rate hikes in 2017, but the timing of the first move will depend on many factors. One factor might be a change in the composition of the FOMC (Federal Open Market Committee) because there is a chance it may become a bit more dovish. With regard to the new Trump administration's plans, thus far they have not had a major effect on the Fed's decisions, as we haven't seen any impacts on macroeconomic forecasts. Chair Yellen was quite explicit in maintaining a wait-and-see attitude towards the new administration's economic agenda. What we do know for sure is that market expectations of fiscal stimulus in the U.S. are quite high.

Donald Trump's fiscal agenda is likely to find sympathetic ears in Congress, given that it is now controlled by the Republican Party. We also know that the U.S. economy seems to be in the later stages of this business cycle, and stimulating the economy in this environment might be inflationary. Whether we experience a reflation-type or a stagflation-type outcome, we cannot predict yet, but it will become clear later on. High inflation pressure might force the Fed to adopt a more aggressive policy stance. The reflation story seemed to be getting some traction in the first quarter, given that we've a bit more positive surprises in the developed markets and this has pushed market-based inflation expectations higher. I would say that a first quarter 2017 hike is probably on the table. What is interesting, however, is that markets still don't really believe the Fed, and they are more dovish than the Fed, especially in terms of expectations for 2018 and 2019. If by any chance markets catch up to the Fed, or they decide that the Fed is behind the curve with the risks of more duration sell-off and the U.S. dollar appreciation.

BUTCHER: How does this impact the outlook for both U.S. and global growth?

GURUSHINA: The global growth outlook is not very impressive, and this is despite the fact that we are now sitting on a big pile of debt globally. Here in the United States, there is now a prospect of fiscal stimulus, and this should improve growth expectations. There is also a chance here in the U.S. that there will be structural changes, deregulation, tax reform. If all these pro-growth policy blocks are implemented, this can improve confidence. This is positive for growth in the near term, as well as lifting the long-term potential for growth.

GURUSHINA: Two potential headwinds are important. First is higher interest rates in the U.S., when the amount of leverage in the economy is actually quite high. This is not just in the public sector, but in the business sector as well. To provide one example, the business debt-to-GDP ratio is now almost as high as in the run-up to the crisis. Another potential headwind, as mentioned earlier, is that the Fed might be forced to be more aggressive in its policy response, if a combination of fiscal stimulus and less slack in the economy fuel inflation.

In terms of emerging markets, stronger growth in the U.S. is generally good for emerging markets, especially if this expansion is accompanied by higher commodity prices. But we see three uncertainties. Point number one is if the Fed continues to tighten, then there is less room for emerging market central banks to accommodate. Point number two is if U.S. dollar strength becomes excessive, capital flows through emerging markets might be curbed, and it will make it more expensive to service debt, which will weigh on growth. Finally, and this will be unique to the new Trump administration, is that we need more clarity on the global trade agenda. This will affect not just growth in emerging markets, but also the profitability of the U.S. corporates, and therefore, the U.S. growth.

BUTCHER: Natalia, thank you.

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