Debate over Medium Term Forecasts
The need to build optionality in this next, and presumably final, leg of the ECB bond purchase program is predicated on the central bank’s commitment to sequencing lift-off on interest rates only after the completion of its asset programs.
And while the ECB is united (sort of), in pushing back on late 2022 rate hikes, there is a very broad and tacit understanding that these hikes could very well come soon after, in 2023, with considerably less certainty than is projected by the ECB leadership over its medium-term inflation forecasts.
Chief Economist Philip Lane, and ECB President Christine Lagarde, continue to emphasize that judging from where the ECB sits now, the medium term forecast is still for inflation to drop back below its 2% target level after spiking sharply higher this year, due to an essentially mean-reversion assumption that energy prices will fall back down, faith that supply constraints will ease in the fullness of time, and a technical drop off in the German VAT tax effect come January 2022.
In making the case for continued aggressive stimulus, ECB President Christine Lagarde, while acknowledging that prospects for medium term inflation have improved, even went so far as to emphasize in a November 15 speech that by the fourth quarter of 2022, Eurozone inflation could be back down at 1%.
That forecast, however, is due to a year-on-year base effect comparison to the massive spike in inflation now, in the fourth quarter of 2021, and does not reflect any certitude on the far more germane, and unknown, questions over the potential broadening of underlying inflationary pressures and expectations.
In a direct rebuttal to both Lane and Lagarde, Bundesbank President Jens Weidmann warned one week later that “the fallout from the pandemic could have a marked impact on the inflation setting. And it could well be that inflation rates will not fall below our target over the medium term, as previously forecast.”
Policy Implications
For policy purposes, the key point is a concern that the gap between the hawkish and dovish views is in fact not that large.
As stated by ECB Governing Council Member and Belgian National Bank Governor Pierre Wunsch, while the 2023 staff forecast is likely to remain below 2%, “it wouldn’t take much for realized inflation in 2023 to be at 2% — one or two surprises or some second-round effects, so just a fraction of everything we’ve seen in the last three months.”
These differences in forecasts will clearly not be resolved over the next days or even weeks, but the ECB will need to build optionality and policy flexibility for the upside as it gauges the momentum behind underlying inflation impulses going into 2022, including when it rolls out the new “modalities” on December 16 for the 2022 Asset Purchase Program.

Li said that in considering the whole picture of the macroeconomic situation, the MOF should study issuing a new debt quota for local governments in 2022 in advance. The amount of new local government bonds next year can be tentatively set at 4.5 trillion yuan, a slight increase over this year.
(*Note, the annual limit of newly issued local government bonds is usually passed by the country’s legislature and policy advisers in March, after the country’s “two sessions.” But the State Council could be authorized to deliver a part of the quota earlier to accelerate financing for investment projects. China issued 4.47 trillion yuan in new local government bonds in 2021, and 4.55 trillion yuan in 2020).
Li expressed satisfaction with the current monetary policy and reiterated the need to make macro policies more forward-looking and targeted, step up cross-cyclical adjustments, and maintain major economic indicators within the proper range and ensure a stable job market.

“At present, China’s crude oil supply is sufficient, the supply and demand of crude oil is very balanced. Although US President Joe Biden wants China to release its strategic petroleum reserves along with the US, China does not have the need to release our SPR immediately. We will take caution in releasing strategic crude oil reserves,” said one senior source.

In practice, China publicly announced a modest release of its SPR twice over the last fourth months, but our understanding is that China has adjusted SPR data almost every month under its own timetable, without any publicly announcement. Perhaps more to the point, on oil policy, China is keen to maintain its relations with Russia and Saudi Arabia rather than be seen to simply embrace a US request.

European Central Bank officials, concerned by the notion that markets may start pricing “premature” rate hikes some twelve months into the future, have pushed back on expectations of a fourth quarter 2022 liftoff from the current negative 0.5% benchmark deposit rate.
*** But even as they insist that this pricing does not conform to the ECB’s own reaction function and forecasts, our understanding is that there is a strong likelihood the ECB will seek to build some optionality into the revised Asset Purchase Program at its upcoming Governing Council meeting on December 16 to allow for a more rapid run-off of the bond purchasing program should inflationary pressures persist.

Finally, West Virginia Senator Joe Manchin reported on his meeting with Federal Reserve Chair Jerome Powell. Via The Hill:
Sen. Joe Manchin (D-W.Va.) told The Hill that he was “looking very favorably,” but hadn’t made a final decision, on supporting Federal Reserve Chair Jerome Powell if he’s renominated as chairman, after the two spoke on Wednesday.
“Well we’re looking very favorably towards that, because I needed that conversation with him. But I have not made up my mind yet. But I’m just saying that it helped an awful lot having him clear up a lot of the concerns I had,” Manchin told The Hill.
This is a political decision and part of that decision will be the difficulty of getting the nominee confirmed. If Republicans were to be largely united in opposition to one nominee, Manchin would be a critical vote, and his leaning toward Powell could help seal the deal (Democrat Jon Tester also leans towards Powell, Warren of course favors Federal Reserve Governor Lael Brainard).

The last paragraphs of today’s just released speech by influential European Central Bank Board Member Isabel Schnabel have been flagged to us by European Central Bank officials as noteworthy and of particular significance. As many of you are inundated with news and speeches, we are flagging and sending just that key, new takeaway, of her speech as it was highlighted to us below. The speech is clear, excellent, and worth a read in its entirety.
“Eventually, if we are serious about fighting climate change, the green transition will need to bring about a measurable further rise in the price of carbon, which can be expected to lead to higher fuel and electricity prices.

These effects may become entrenched in expectations if people start to anticipate them.

Similarly, some of the bottlenecks we are observing today may not only reflect the reopening of our economy but also structural forces, such as the secular shift to electric vehicles. Adapting supply capacities to such shifts in demand can take several years.[11]
In other words, if some factors that are by nature temporary – such as supply and demand imbalances – are stronger and last longer, then inflation may become more persistent and broad-based.”
In reading that key passage from Dr. Schnabel’s comments, we believe they are especially significant in tying socially desirable, environmentally conscious green policies to inflation, to the risk and potential for higher energy prices to stick longer than initially, and still widely assumed, by the ECB, and to its potentially longer lasting impact on inflation expectations and dynamics.

Bottom Line: The economy is gaining steam in the fourth quarter while inflationary pressures remain elevated. That’s a mix that will push the Fed in a hawkish direction. Watch for the consensus to drift as Bullard suggests, toward starting to lay the groundwork that would allow a policy pivot that accelerates tapering or even pulls rate hikes earlier in 2022. Discount the doves as the Fed has been pulled in the direction of hawkish Presidents because the data runs in a hawkish direction. Places to watch include warnings about high inflation and reassessments of what constitutes full employment.

My focus this week is on the retail sales numbers. The Biden administration and the Fed are spinning a story that goods spending will fall as the economy normalizes and this transition will alleviate inflation. Wall Street, however, is looking for a 0.9% gain in retail sales excluding autos and 0.7% in the control group. Be wary of the potential for an upside surprise. These are nominal figures so inflation may be pushing them even higher. Moreover, note that the Chicago Fed estimates retail sales excluding autos rose 2.6% in October...

This feels to me like a potentially unstable situation. I continue to play with this scenario because it has a knife edge feel. With long yields held down, right now it looks like the Fed doesn’t have a lot of room to cool growth without inverting the yield curve, which suggests we don’t have a lot of space between fast growth and recession. This makes sense in a world where the Fed has flooded the economy with unneeded financial accommodation. The Fed maintained emergency levels of accommodation long after the emergency ended and continues to add accommodation albeit at a slower pace. What strikes me is that this acts with a lag. The maximum impact of the accommodation will be reached after asset purchases stop. That’s a long time to let this system run unimpeded.
I bring up this scenario because it raises the possibility that the Fed may need to focus on reducing the balance sheet before hiking rates. That’s not on the radar yet; we don’t have any visibility on the Fed’s balance sheet plans after asset purchases end. All the discussion is on rate hikes. As we move closer to March, balance sheet policy will need to come into focus. That’s something I will be looking for.

Finally, an even trickier issue. Will the recent trends in fixed income markets continue this week? Recent moves – pulling forward rate hikes, higher short rates, bear flattening – have been sharp and swift. I have been happy to ride that train, but I am getting to the place where I am concerned that these moves are now vulnerable to near-term repositioning. I think part of these moves are attributable to investors caught on the wrong side of the flattening and unwinding positions ahead of month-end. That said, I don’t want to get in front of this train. Powell could do everything I said above and still inadvertently say something market participants perceive as hawkish that won’t be cleaned up for another day or two. Getting off the train but not in front of the train seems like a more comfortable place for me going into this week.

So what’s the Fed going to do? The Fed doesn’t like to break things. The whole tapering process was designed to avoid that exact outcome. As always, back to the baseline. Based on the messaging prior to this meeting, the Fed intended for us to expect:
1. A tapering announcement, with tapering beginning in November and ending in the middle of next year, a pace of $15 billion per month, proportionately distributed between treasuries and MBS. This is operationally the same as $20 billion per meeting.
2. A reiteration of the basic “inflation is transitory” story with the acknowledgement that the process is taking longer than expected. I think the Fed needs to modify the language in the statement accordingly, but at the same time can’t drop the word “transitory.” If “transitory” is not in the statement, markets are going to overrun the Fed.
3. Powell will highlight the upside risks for inflation but will add that the Fed won’t know the true inflation story until at least the beginning of next year, more likely the end of the first quarter. The message is that the Fed intends to let the inflation story play out for some time yet.
4. Powell will continue to lean heavily on the inflation expectations story to justify the Fed’s faith in the “transitory inflation” forecast but at the same time will likely acknowledge the data implies greater inflation risks. The Fed likely thinks it already has room to maneuver because there is space between the end of the taper and the SEP-implied forecasts to pull rate hikes forward.
5. Powell will caution that structural changes to the labor market mean that labor force participation may not entirely return to pre-pandemic levels but add that the economy is still a long way from full employment. He will likely repeat his pre-blackout statement that reaching full employment by the latter half of next year is very possible. This is code for “it’s OK to price in rate hikes for the latter half of next year because we may hike rates if the data confirms full employment.”
6. Watch for Powell to say that “policy is in a good place.” Similarly, this is a signal that Powell isn’t ready to fight the markets, a sort of “we think our policy stance is correct and aren’t changing it for you.” Instead, Powell can see the risk relative to the September dots and doesn’t want to prevent markets from preparing for those dots to rise in the December and March SEPs. This would help avoid a surprise like that which occurred when the June SEPs were released.

Premier Li Keqiang, who is also the head of China’s National Energy Committee, presided over three meetings in Zhongnanhai over the last ten days.
In those meetings, he stressed that an unprecedented energy crunch is sweeping much of the world even before the Northern Hemisphere winter season fully sets in, when more electricity and heat will be needed in homes and in factories.
Li called on relevant departments under the State Council, and government at all levels, to work together to ensure that this winter the supply of electricity, coal, crude oil, and natural gas is fully guaranteed, electricity and heating for people’s livelihoods is guaranteed, and the normal operation of industrial and transportation production is ensured.

The Governing Council of the European Central Bank is scheduled to meet again on Thursday, October 28.

With important decisions on the future path of the ECB’s bond purchase programs looming at its subsequent, December meeting, the October meeting will serve mainly, in the words of one official, to “gauge the mood” around the table on inflation.
Our understanding is that these deliberations are likely to lead to a change in the wording of the language around inflation in the ECB’s communications. To what exactly, we are not sure, but the upside directionality of the inflation deliberations, and further upside forecast revisions come December, we believe are all but certain.

There will be plenty of Fed speak this week. I have my eyes on speeches by Governor Christopher Waller (Tuesday) and Vice Chair for Supervision Randal Quarles (Wednesday). Both will be talking about the economic outlook and should help gauge the direction of the Board; I am looking to see if they push the Board in a more hawkish direction; similarly, Governor Michelle Bowman gave a hawkish speech last week. In addition, Chair Jerome Powell will take part in a panel discussion on Friday hosted by the South African Reserve Bank. At this point, text and Q&A are to be determined. If the Fed is looking to tilt the discussion toward the hawkish side (more warnings about the persistence of inflation, medium term tightness in labor markets, need to protect against rising inflation expectations), we could see Quarles and Waller pave the way for Powell later in the week. Or Powell could push back on such talk, but it seems to be the overall direction.

The staff work for the next quarterly forecast revisions has not yet begun in earnest, but it appears that further revisions upwards of somewhere in the magnitude of 0.2% for next year, putting inflation at around 1.8%-1.9%, are likely again in December, which will also debut the 2024 forecasts. There will likely be upwards revisions to the 2021 and 2023 inflation forecasts as well.
That will necessitate changes in advance to how inflation pressures, these forecasts, and continued policy accommodation are characterized.
The hawks – and we hesitate to even use that term at the ultra-accommodative ECB — will note that the Governing Council agreed in its policy review this summer that it would incorporate the impact of Owner-Occupied Housing (OOH) into its decision making. As you will recall from previous SGH reports, this is estimated to add around 0.2% to inflation, even if Eurostat has not yet formally incorporated OOH into its inflation measures.
And so, miracle of miracles, come December the ECB it now appears will show a forecast by that measure effectively at or slightly above its 2% inflation target for next year. And that will open an interesting debate over overshoots, and for how long and by what magnitude the Governing Council will fuel, and let these inflationary pressures run.

Li stressed that electricity demand for high-tech companies must be absolutely guaranteed, even while it would be necessary to continue to impose power cuts on high energy consumption enterprises, as well as for enterprises temporarily relocated to China from Vietnam, Malaysia, and other ASEAN countries due to the Covid Delta variant.
Some provinces, he said, have been too rigid in meeting emissions reduction targets, in the process triggering harmful undulations for industrial production, and they would need to carry out the country’s “dual controls” and “dual restrictions” more prudently, with power outages only used as a last resort, and with advance warning, to prevent overall grid risks.

...my opinion is that I doubt Ambassador Tai would use the CSIS forum to break ground on any high-level decision or shift on the existing tariff or trade regime in place, which I think would come in a formal announcement from the appropriate political levels depending on the intended magnitude of the announcement. But I do not pretend to be privy to what Ambassador Tai will say and am interested to hear.


But here is out take on the overall US-China trade/economic situation:
The administration will talk and stand tough on some important issues that the US needs/wants to address, unfair trade practices, transparency, subsidies, Taiwan, human rights, Uighurs, Hong Kong, all with less and less effect, but we believe the goal is to improve and de-escalate in general on economic issues. Why? Growth, economy, markets, consumers, increasing inflation and commodity, supply chain concerns, good old-fashioned profits and lobbying, they don’t like “Trump-era” tariffs really, would like to make the case that they have not been effective, can conduct a multi-faceted (as opposed to the old one track) policy designed to help the economy and working people, manufacturing, but tough on security issues. We have been writing this for a while, more or less, been quite a bit out there on it I have felt.
Often people get more rattled (albeit increasingly less so) by hawkish rhetoric, always they rightly cite the domestic US political difficulties to any easing with China, but which can be overcome with the right concession/cover, so we talk and speculate about how the trade plays out politically. Phase One will be declared dead at some point, I don’t know when, but we have thought there would be movement on trade before year end, which is not so far away now.
Massive, massive corporate lobbying (Chamber of Commerce, US China Business Council, etc.) and financial industry lobbying one might reasonably presume may come into play as well — how do I phrase this delicately! And there has been lots of communication/dialogue between American and Chinese notables, not just private sector participant/sponsored, but with officials as well.

As to more specific measures, our understanding is that China’s State Council approved an immediate expansion of coal imports, mainly from Russia, Mongolia, and Indonesia. (Note – Indonesia is China’s largest coal supplier, followed by Russia and Mongolia. China imports roughly 300 million tons of coal, which is around 10% of its total consumption).
The State Council also asked 20 provincial governments to implement differential electricity pricing for power usage peaks and valleys as part of a peak shifting power supply policy, and to provide subsidies to power generating enterprises.
It also urged coal producers to seek out and secure additional supplies.

Regarding inflation, Brainard expects this year’s surge to be transitory, placing particular attention on used-car prices:

Next let's consider price stability. Inflation is currently elevated. This is creating challenges for consumers and businesses alike. But the high inflation readings from the spring and early summer were disproportionately driven by a few sectors experiencing specific supply bottlenecks. In May and June, new and used vehicle prices accounted for half of the outsized monthly increases in core consumer price index (CPI) inflation. These categories were lesser contributors in July, and in the August CPI their joint contribution declined to essentially zero, as prices finally began to retreat for used cars, offsetting increases in new car prices.

With that in mind, note this from Black Book:

Traditionally, as we move past Labor Day, values begin to decline, with the largest portion of the yearly depreciation typically occurring in the fourth quarter. However, that is not the case this year, we’ve now had four consecutive weeks of overall market increases in wholesale values. With new inventory not expected to improve until later into 2022, wholesale prices are anticipated to remain at elevated levels for the foreseeable future.

The seasonal factors will magnify used car price growth if they are again rising when seasonally they should be falling. Brainard recognizes such a possibility:

So, I expect inflation to decelerate, and pre-COVID inflation dynamics to return when COVID disruptions dissipate. But with Delta disrupting the rotation from goods to services and prolonging supply bottlenecks, it is uncertain just how fast and how much inflation will decelerate over the remainder of the year and into next year.

Looking ahead, my instinct is the Fed’s inflation forecast for 2021 is still too low; 3.7% feels like a minimum that I suspect depends on used car prices collapsing. The unemployment forecast for this year reflects the growing concern we had noted across the Fed that the labor force was not returning as quickly as expected, but now feels perhaps overly cautious to me. We are at 5.2% now; an exceptionally good report could take that to 4.8% in one fell swoop. Together that suggests that the December dots will move the majority expectations of a rate forecast to a full hike in 2022.