Chips Ban Retaliation

Our understanding is that five ministries and commissions under China’s governing State Council are jointly studying countermeasures against the latest round of US chips bans against China. The Ministry of Commerce is expected to announce countermeasures against the US shortly after the 20th National Congress at the end of this month or early next month.

In the words of a senior Chinese official:
The move [chip ban] is the toughest measure the US has taken against China’s high-tech sector so far. It does have a serious short-term impact on China, but it will definitely not cause China’s high-tech companies to go out of business or bankrupt. How much impact the latest move has on China’s artificial Intelligence and chip sectors depends on how broadly Washington enforces the restrictions. In the long run, Washington’s extreme export control toward China will be difficult to sustain….

...EU energy ministers also agreed as we had expected to task the Commission to develop a different price benchmark for LNG so that the sector can dump the volatile and no-longer-representative-of-reality Dutch Title Transfer Facility (TTF) that is linked to pipeline gas. That will take time too.

EU energy ministers are to meet in November to approve whatever the Commission produces on October 18th...

...There was still no agreement on Wednesday on introducing any price caps on gas — for all the reasons discussed in our last report.

And while it is unclear yet if any price caps will be presented as an option by the Commission on October 18 or not, we believe that option remains highly unlikely...


...On Wednesday, October 12, European Union energy ministers agreed that the European Commission should present on October 18 a proposal for joint natural gas purchases by the whole EU, just like the bloc did for COVID-19 vaccines, to avoid one EU country outbidding the others.
This is relatively low hanging fruit in political terms, although it does involve a change of heart by Germany and the Netherlands, whose governments some time ago did not support joint purchases as they believed they were in good position to negotiate deals and pay what would be needed if necessary to keep their industries running.
The joint buying, however, would not start before mid-2023, the ministers agreed, so it is not an imminent measure, even if agreed sooner.

Joint Issuance
Despite press reports to the contrary, the idea of new, jointly issued EU debt to deal with the energy crisis does not seem to be happening for now.
The calls for new joint debt issuance have come largely from the Commission and given that it was French and Italian commissioners calling for it, one might reasonably suspect these had the blessing of Paris and Rome. But there is still strong pushback from Germany, and the usual group of fiscally conservative northern countries hiding behind Berlin.
The German case is simple and remains that there is still a lot of unused money from the recovery fund and the RePowerEU project that could finance whatever is needed, and there is therefore no point in borrowing more if the EU has not used what it has.
German officials choose to highlight the bigger figure of 600 billion euros still unspent from the EU recovery plan to make that case – which is the amount of money that has yet to be paid out from the recovery fund since actual disbursements so far have amounted to only around 200 billion euros...

...The 19th Communist Party of China Central Committee concluded its seventh plenary session in Beijing on Wednesday afternoon, local time (October 12).
Xi Jinping Thought Through 2049
As we have written before, the seventh plenum decided to submit the draft amendment to the CPC Constitution to the 20th Central Committee emphasizing “Comrade Xi Jinping” as a “well-deserved” “people’s leader,” and to explicitly write into the CPC Constitution the statement of “Two Affirmations” that says: The Party has established Comrade Xi Jinping’s core position on the Party Central Committee and in the Party as a whole and has defined the guiding role of Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era...

...We think the more hawkish FOMC participants have the upper hand in these arguments. After so many missed predictions that inflation would soon decelerate, the doves have an uphill battle when arguing for a pause ahead of sufficiently supportive data. But the more restrictive policy becomes, the bolder the doves will become.

Bottom Line: The SEP-implied terminal rate is as little as three meetings away. It is right on top of us. And the Fed will step up the discussion of slowing the pace from 75bp to 50bp, as that too is in the SEP. There will be a push to find a place to pause even if inflation remains elevated. We saw that on display this week. Ultimately though we think the more hawkish FOMC participants will continue to argue that the Fed needs to maintain upward pressure on rates until the data gives up something in the form of sustained softer inflation or weaker labor market outcomes. There is a path to reaching the terminal rate in January, although we think the data won’t allow for that and the hawks will continue to drive policy rates above the current SEP-implied terminal rate...

...The Fed continues to keep us focused on the current SEP-implied terminal rate. Buried inside that direction is an implied step down in the pace of rate hikes. Eventually the Fed will need to find a time to start gliding to the terminal rate, but the July meeting was too early and left market participants with too little direction on the Fed’s reaction function. After the third 75bp rate hike in September and a fourth in November, rates will be high enough that the Fed can more credibly tell a policy lags/two-sided risks type of story. Still, at some point the data needs to cooperate before the Fed can have any real confidence that the terminal rate is in sight...

...So, having already tightened 250bp since May, the RBA broke ranks with its global peers this week by delivering a smaller rate hike than expected, and instead pitched its cash rate at 2.6%, right around the so-called neutral rate (which neither stimulates or tightens conditions)...

...Worse though is that the BLS revised the series higher such that if core inflation continues at the average pace of the last 6 months, 0.38%, it will end the year at 4.9% compared to the 2022 forecast of 4.5% in the Fed’s most recent SEP. This suggests that the underlying momentum in the inflation data heading into 2023 will be higher than the Fed anticipated just a couple of weeks ago, and raises the risk that policy rates will climb above the 4.5-4.75% median dot in the SEP...

...QT and Balance Sheet Discussions

Putting it all together, the first meeting of 2023 will be the point at which the ECB, having crossed into some sort of neutral policy zone, will as suggested by ECB President Christine Lagarde in a speech earlier this week then decide on the appropriate mix of additional interest rate hikes and balance sheet reduction.
With quantitative tightening as a major policy decision now looming on the horizon, technical work is underway already to map out feasible options, and the Governing Council will start these discussions at the upcoming, October meeting...

The Fed will retain a hawkish posture until the data breaks in favor of sharply lower, and sustainable, job growth or inflation. We think it is literally impossible to get compelling evidence that the Fed is on a path to price stability by the time of the November FOMC meeting; even getting such evidence by the December meeting feels like something of a stretch. And we can’t emphasize enough how important it is that we see such data before we can expect the Fed to pivot to a meaningfully more dovish stance. It is simply the case that any more dovish voices within the Fed have been proved wrong time and time again during this cycle and those voices can’t gain any traction at this juncture with theories alone. It needs to be hard evidence.

...Worse though is that the BLS revised the series higher such that if core inflation continues at the average pace of the last 6 months, 0.38%, it will end the year at 4.9% compared to the 2022 forecast of 4.5% in the Fed’s most recent SEP. This suggests that the underlying momentum in the inflation data heading into 2023 will be higher than the Fed anticipated just a couple of weeks ago, and raises the risk that policy rates will climb above the 4.5-4.75% median dot in the SEP...

...Asked and Answered

Final thoughts heading in the FOMC meeting, in Q&A format.

Why not just pull the trigger on a 100bp rate hike?

Great question, if you know you are still some distance from where you are going, why not just step up the pace? And wouldn’t a surprise hike be the best way to send a hawkish message? And doesn’t the Fed keep falling behind the curve, so isn’t this a chance to finally make some real progress on catching up to the curve? All these points are accurate, and it’s why we can’t say there is no risk of 100bp this week.

Perhaps the best argument for a 100bp is that this meeting mirrors the choices the Fed faced in November 1994 when then-Chair Alan Greenspan pushed the option of 75bp over 50bp to surprise on the hawkish side.

But Greenspan didn’t have the Summary of Economic Projections to bolster the Fed’s messaging with forward guidance. The communications structure is much more sophisticated now and will be unmitigatedly hawkish. So we still think the Fed opts for 75bp because it already passed on the bigger hike once in July, the last CPI number only tells us that inflation is not decelerating, and a number of FOMC participants were leaning toward 50bp ahead of Federal Reserve Chair Jerome Powell’s Jackson Hole speech which suggests it might be difficult to get a consensus on 100bp. A 100bp hike also aggravates the problem of the step down, the Fed doesn’t like to surprise the markets and induce additional volatility, it really doesn’t know where it’s going despite the SEP, and the Fed probably believes it needs some space to keep hiking until inflation softens...

...Will the Fed really raise the terminal rates 100bp in the SEP?

As we wrote this week, we think a sizeable increase in the terminal dot is the logical conclusion of normalizing 75bp rate hikes, but this is an aggressively hawkish view and would be a big lift for FOMC participants to pencil in. Repeating what we said yesterday, we think the risk for the dots is on the upside of the 50bp minimum increase in the terminal rate that we could expect. It’s probably too hawkish to expect more than a 75bp increase in the terminal rate even if anything less indicates the Fed anticipates the cycle is almost over...

...Will the Fed raise the estimate of the longer-run policy rate?

We heard this question frequently from clients last week. The general view, like we have written, is that the Fed’s estimate of the longer-run rate is an anchor on the long end of the yield curve, and rates can really move higher if the Fed was to cut ties with that anchor.

With the 10-year treasury yield now well above 2.5% and the economy still chugging along, there appears to be some reason to think an upward revision should be considered:



That said, we have yet to hear a Fed speaker say they are revising up their estimate of the long-run real neutral rate. I think the sense is that the factors that grind out an approximately 0.5% real neutral rate have not changed since the pandemic, and consequently it would be premature to raise the estimates.

In my opinion, the potential to raise this estimate is an upside risk for yields, but I am not seeing it just yet. We will keep shaking this tree. Personally, I would very much like to see what happens if they stopped trying to make this estimate...

...What is the terminal rate in this cycle?

I have no defined sense yet of the terminal rate, although I think the odds favor more than 5% and not less than 4.5%. Traditional rules say the Fed is still behind the curve. This is true with even generous interpretations of traditional rules. St. Louis Federal Reserve President James Bullard presented a minimalist Taylor rule in May, concluding the appropriate policy rate at the time was 3.63%. The same calculation now yields 4.5%. But this is an extremely generous rule. It assumes the real neutral rate is -0.5%, compared to the SEP estimate of 0.5%. Making that change alone pushes the appropriate policy rate to 5.5%, and that still might not be enough given that Bullard assigns no impact from unemployment lower than its natural rate. We could be a long, long way from the appropriate policy rate which means that policy remains accommodative and thus the lagged impact of policy is still stimulative. Let that sink in...

...Regardless of the dots, Powell will attempt to maintain a hawkish tone at this press conference. Now that we are past the peak recession story, and there is no convincing evidence of any sustained slowing of inflation, Powell should be free to take on a tone more like Sintra and Jackson Hole and less like the July press conference. I think Powell will want to follow Waller and emphasize the uncertainty about the path of policy:
I expect that getting inflation to fall meaningfully and persistently toward our 2 percent target will require increases in the target range for the federal funds rate until at least early next year. But don’t ask me about the policy path because I truly don’t know—it will depend on the data...

Fed on Path for Another 0.75-Point Interest-Rate Lift After Powell’s Inflation Pledge
Fed officials face questions over how high to lift rates by year’s end and how fast to get there
By Nick Timiraos
Updated Sept. 7, 2022 10:29 am ET
In a speech Aug. 26 in Jackson Hole, Wyo., Mr. Powell underscored the central bank’s commitment to boosting interest rates enough to lower inflation from 40-year highs. “We will keep at it until we are confident the job is done,” he said.
His remarks and tone placed him among the Fed officials who favor a more aggressive pace of rate increases than others, said Tim Duy, chief U.S. economist at research firm SGH Macro Advisors. Raising rates by 0.75 percentage point would fit that approach, he said.
Mr. Powell’s speech showed he “very much did not want to leave the impression that the Fed would fall short on fighting inflation,” Mr. Duy said.

Several officials have signaled a desire to raise the fed-funds rate closer to 4% by year’s end—or about 1.5 percentage point higher than its current level. That could be accomplished in rate increases of various sizes at each of the three remaining Fed meetings this year.
The hawkish approach would point to a 0.75-point rate rise at the coming meeting, followed by smaller increases at the next two, analysts said.
“The argument is you’re going to have to go much further than where policy rates are now, and the risk of overshooting is still fairly low,” said Mr. Duy. “And you would rather try to get a little bit more ahead of the curve rather than risk falling behind further.”

A 75bp move on September 7 to 3.25% would position the bank to calibrate the next phase of its policy cycle -– an enviable position that most other central banks have yet to achieve -– where it can begin to guide rates via smaller increments to a restrictive terminal rate that truly will be guided by incoming data.
Still chasing inflation but no longer chasing a neutral rates setting, the BOC then will deliberate whether it needs 50bp or 75bp in tightening over its two remaining meetings this year to finish 2022 around 3.75% or 4%.
With no accompanying press conference this week, the central bank may drop the “frontloading” reference in the statement once rates are at neutral. That change would denote the largest hikes are behind the BOC. Its July statement described the 100bp move as frontloading “the path to higher interest rates.”
We do, however, expect the bank to retain statement language indicating that rates will need to rise further, particularly given inflation still remains too high for Macklem to declare a stopping point.

The Reserve Bank of Australia (RBA) is likely to deliver its fourth consecutive 50bp rate hike this week, taking the cash rate to 2.35%, as it seeks to push rates into more restrictive territory to get inflation under control despite a torrent of protest over a housing market downturn.

...I think we can already see the points that represent the central messaging at this week’s upcoming Jackson Hole conference. I anticipate that sideline discussions will emphasize the hawkish points of agreement discussed above: rates need to be in restrictive territory and stay there for an extended period, restoration of price stability is the number one job, and don’t believe we won’t accomplish that goal. There is less unanimity here than it appears, at least as far as the terminal rate is concerned, and financial journalists can press to find divisions should they choose to do so, but that basic messaging should be uniform across speakers...


...Bottom Line
FOMC participants might share a common objective in restoring price stability, but with rates now in the range of long-term neutral, there is no consensus among members of the ultimate level of policy rates necessary to meet that objective. We think that the consensus will eventually emerge on the higher end of the estimates, but that remains to be seen. That said, there is a very unified theme in the messaging, and Powell can reinforce that theme. Market participants are hawked up going into this week, and that sets up the risk they will be disappointed by anything that feels less than a total repudiation of the July meeting and minutes. That said, I also get the sense the market participants would like to take on a solid, one direction trade as they return from summer breaks, and if they want to focus on the hawkish messaging, they can take short term rates higher.

With all the focus on rate hikes, there was one additional comment in today’s interview that did not get much coverage, but which we found intriguing. That was to float the possibility that the size of the ECB’s balance sheet and the reinvestment of the bonds held under the Asset Purchase Program may be a matter of discussion by the Governing Council soon.
We have, truth be told, assumed that reinvestments would be on autopilot for a while, so any material discussion, if it were to happen, would be newsworthy.

...Stimulus, as in the first half, will come largely from the fiscal side.

There, the CFEAC stressed that governments at all levels should continue to accelerate fiscal expenditure and shore up domestic consumption in the second half of 2022. It approved fiscal expenditures of 13.821 trillion yuan for the second half, an increase of 2.9% from the same period last year, and an increase of 7.2% from the 12.888 trillion yuan in H1 2022. It called for China’s fiscal expenditure to grow by double digits year over year in H2 to achieve Beijing’s full-year 2022 fiscal spending target of 8.4% growth.

The 12.888 trillion-yuan H1 fiscal expenditure figure represents a 5.9% increase from the same period in 2021 and makes up 48.25% of the 26.71 trillion yuan full-year 2022 fiscal spending target. China’s local governments, encouraged by Beijing, issued 3.41 trillion yuan worth of new special bonds in the first half of 2022, a 93% frontloading of the 3.65 trillion-yuan annual quota for new special bonds this year, and leaving little room for additional new issuance this year under the current quota.

To help steady economic growth from Q4 2022 to H1 2023, local governments will therefore pull issuance of new special bonds from the 2023 quota into October and November of this year. About 1.8 trillion yuan of special bonds are expected to be issued in advance...

Bottom Line: The CPI report is on net good news, but not good enough to deter the Fed from ongoing rate hikes. It leans the odds back toward 50bp at the next meeting, but not decisively so. While there is a heavy focus on the next meeting, this report alone doesn’t suggest we should expect a lower rate path even if the Fed opts for 50bp. That choice actually argues for a higher path of rates assuming elevated inflation remains persistent. If the Fed concludes that it can’t restore price stability without a recession, then 50bp would only be delaying the inevitable and 75bp becomes a more obvious option.

Now Bailey, concerned about so-called second round effects feeding into inflation, looks set to cross over to recommend 50bp, and with the support of at least his chief economist Huw Pill, that vote should carry the day. Both supported only 25bp in June.
MPC members are fretting that price and wage setting behavior could entrench inflation at a higher level. In the most recent comments by a BOE official on July 7, Pill noted that the BOE’s guidance reflects “a willingness – should circumstances require – to adopt a faster pace of tightening than we have seen implemented in this interest rate cycle so far.”
Three of the four external board members – Jonathan Haskel, Michael Saunders, and Catherine Mann – already wanted 50bp in June. Of the four remaining votes, at least one, if not two other members, might also vote for 50bp.
Even as the Bank most likely opts for the bigger increment tomorrow, it will be careful not to suggest a string of 50bp moves will follow, nor even that it won’t sit out moves later this year. Additional guidance Thursday will, however, shape expectations about how quickly the Bank intends to get to a neutral rate around 2.25%.