Source: Northern Trust

Hawks and Doves

• The U.S. Federal Reserve meets next week to discuss monetary policy.  The extremely accommodative stance taken recently has led some to call this the most dovish Fed in decades.  (And as the following article suggests, it may become even more dovish over the next year.)  Its willingness to keep the spigots fully open is alarming some, but cheering others.
• A bit of background is in order.  While most of the world’s central banks seek to manage inflation, the Fed is the only one also tasked with pursuing maximum employment.  Traditional thinking has held that the two elements of this “dual mandate” aren’t easy to reconcile: at times, it is hard to achieve one without retreating on the other.
• But this “Phillips Curve” mode of thinking has not held up well in recent years, as the United States has simultaneously experienced low inflation and low unemployment.  Further, the notion that inflation is everywhere and always a monetary phenomenon has also come under question as the linkage between money supply growth and changes in the price level has weakened.  Two central tenets that have informed Fed policy for decades are no longer as helpful.
• The past several recessions have seen very slow recoveries in the labor market.  The nature of the pandemic recession is a bit different; a durable reopening of the economy this summer should bring scores of workers back into the labor market and allow those working part time to resume full-time work.  But it is unlikely that employment rates will come anywhere close to their January levels for a long time.  The Fed is intent on accelerating this process, and feels strongly its objective can be achieved without pushing inflation out of bounds.
• Current governor Lael Brainard was a rumored candidate for Secretary of the Treasury, a role that went to former Fed chair Janet Yellen.  Brainard’s history of dissenting from board decisions to loosen regulation may align well with Biden’s priorities to increase the role of financial regulation, especially regarding climate matters.  She is certainly in line for a leadership role at the Fed.

China's Two Sessions

• Beijing is seeking to cut back its fiscal support for the economy.  It has given emphasis to reducing its debt burden as well, which grew by a whopping 30% of gross domestic product (GDP) in 2020. (By comparison, the U.S. has approved aid of almost 25% of GDP to fight the pandemic.) The central government’s budget deficit-to-GDP target has been set at 3.2%, compared to 3.6% last year.  The special purpose bond issuance quota for local governments has been scaled back slightly to RMB 3.65 trillion ($564 billion) from RMB 3.75 trillion last year.  Beijing, as the first major economy to emerge from economic shocks of COVID-19, will not be issuing additional COVID-19 bonds this year after having sold over $150 billion in 2020 for pandemic relief efforts.
• Though focusing on normalizing monetary policy and debt reduction bodes well for China’s long-term economic health, it presents a near-term risk.  China entered the pandemic with high levels of credit risk.  Close to 40 Chinese companies defaulted on nearly $30 billion of bonds (domestic and offshore) last year, up 14% from 2019.  That number is only going to rise as policy tightens with renewed emphasis on deleveraging.  Bond market observers will recall the deleveraging of 2017, which sent Chinese corporate and government bond yields to multi-year highs before reversing course in 2018 as the U.S-China trade war took hold.
• Beijing is also seeking to reduce dependence on foreign technology and increase competitiveness with the United States.  Policymakers are aiming to give larger focus to high-tech industries such as robotics, artificial intelligence and quantum computing, along with the rare earth materials that are essential to circuitry.  For these purposes, China is set to boost research and development spending by 7% annually to bring total spending to $580 billion by 2025, compared to about $550 billion spent by the U.S. in 2018.
• Transitioning to new growth drivers will be the most daunting task for the Chinese economy.  China is gradually losing its demographic dividend due to its aging population, and the economy relies heavily on labor- and energy-intensive industries for growth.  As technology and climate change bear down on China, engineering a transition to a new lower-carbon economic model is going to be a tough job.  The plans set out at the Two Sessions conclave are noble aims, but more sessions will certainly be needed to ensure that they are met.