Central Bank Independence: Markets Vs the FED!

As the world enters a new phase of protracted uncertainty, prompted by trade wars, the tech sell-off in the U.S. and a populist upsurge, which bode ill for government spending and fiscal sustainability. The Federal Reserve is now poised to raise interest rates twice in 2019, at the behest of markets — or not — emerging markets with dollar-denominated debt are likely to be adversely affected by the Bank’s current tightening trajectory. Nevertheless, as investors chase high yields, the record capital outflows from DMs are unlikely to recede.

Investors will continue to balance political risk against high yields, and desert, what they think is a Fed policy mistake. But market psychology couldn’t be more wrong. Even so, as escalations in the U.S. — China trade war ebb, Ems could benefit from the capital flows, which should assuage debt servicing cost, somewhat.

New day for Central bank policy

Admittedly, the trade war caused the FED and market participants to pare back both U.S. and global growth forecast. The tech sell-off did all but deter talk of policy mistakes. Even so, an escalation in the U.S. — China trade war seems a remote prospect as China has resumed purchases of U.S. soya beans and plans to address concerns regarding its industrial policy comprising intellectual property, subsidies for domestic companies and other market distortive practices — claimed by the U.S.

U.S Stock Valuations Methodologies are Flawed!

The markets, however, expect a deterioration in the trade outlook. This is now largely priced, with the justified sell-off in U.S stock markets causing investors to reassess risk premiums. Nevertheless, the latter’s pricing is flawed and miscalculated as U.S. stocks are inherently overvalued, not least because valuations tend elucidate country-specific factors such as size, revenue and branding. i.e Facebook, Apple, Netflix, Alphabet, with Amazon appearing less overvalued when compared to its peers in the FAANGS.

The U.S. stock market correction will persist in 2019, but no reason to fret just yet

I expect the step-by-step correction in the U.S stock market to persist through 2019. This is all the more likely as the effects of the 2018 fiscal stimulus wears off. This correction is justified because the additional capital from the tax-cuts was used to artificially inflate companies share prices through a morally reprehensible mechanism called “share buy-backs”.

This short-termism saw little investment towards activities that will boost companies’ stock prices in the long run. These span research and development, diversification and investment in employees’ i.e human capital — an important driver of competitiveness and profit margins.

As such, the downward spiral in U.S stocks — especially tech stocks — will persist until fair valuations begin to emerge. This has caused markets to reprice expectations of FED rate hikes in 2019. This is especially the case as the outlook for profits have gotten incredibly dire!

FED rate hikes are justified

Stock markets need respite, but FED policy, while cognizant of stock market turmoil, is determined based on more lasting economic indicators such as inflation, unemployment and GDP growth; all of which are poised to perform well above the par in 2019 and account for the adverse effects of the trade war and domestic indicators. In spite of sound economic data, the self-reinforcing market psychology now sees a recession as imminent. They couldn’t be further from the truth as the yield curve could be a poor predictor of recessions. This is because the term premium may now be lower than FED rate hikes; as such yield curve inversions could become more likely, but by no means precede a recession.

Three Fed Rate Hikes remain Likely

One could even argue that three Fed rate hikes in 2019 remain a real prospect should the de-escalation the in trade war prove lasting or economic indicators surprise on the upside. Rising producer costs from the trade war could become increasingly felt in consumer prices, depending on the extent and rate of pass-through from businesses to consumers.

Central Bank Independence under threat!

Following the election of populist governments in the U.S, an autocratic president in Turkey and Narendra Modi in India, Central banks must now grapple with the ballooning government debt, and market integrity or willingness to repay debt in crisis-prone Argentina and Pakistan. Nevertheless, the Fed as reasserted its independence by conducting monetary policy independent based on economic data rather than President Trump’s tweets or unjustified market pricing. This is unlikely to change in 2019!

In the unlikely event that jittery markets caused the Fed to reassess its rate path, this could occasion profound policy mistakes. The likes of which could precipitate the next crisis. Meanwhile, Central Banks independence will come under attack from populist leaders, not least market expectations. News about monetary policy has been found to play a significant role in inflation and growth dynamics. But as central bank forward guidance and forecasts do not impair market functioning, the reverse should not be allowed to happen via “market expectations”

I am an economist and contributor to Nkafu policy, a think tank. I cover global economic, fiscal and monetary policy with policy and asset price implications.