Fed has to support growth even if it means higher inflation

Jan Dehn, head of Research at Ashmore discusses why the Fed has to support growth even if it means higher inflation, the Brazilian government’s 2016 Budget, and looks at new data from China’s SAFE, which showed that domestic corporates neutralised a significant amount of USD short positions in August.

He also explains why Russia’s Elvira Nabiullina deserved to be awarded Euromoney’s Central Banker of the Year Award for 2015.

A Hobson’s Choice: Fed has to support growth even if it means higher inflation

The myopic fascination with pinpointing the precise meeting at which the first hike takes place entirely misses the real lesson investors should glean from the Fed’s decision last week, namely that it will be almost impossible for the Fed to undertake any meaningful monetary tightening as long as financial asset prices are so inflated, as long as the economy is so unproductive, as long as there is so much debt and as long as the USD is so strong.

What will happen when inflation returns in earnest? None of the factors that prevented the Fed from hiking last week are likely to have gone away. Hence, the return of inflation will only serve to remove the Fed’s remaining freedom to do nothing – a freedom it exercised last week.

Returning inflation will force the Fed to choose between preserving a fragile economic recovery and crushing inflation. Both are not possible at the same time due to the state of the underlying economy. Hence, this is really a Hobson’s Choice, that is, given the prevailing conditions in the economy and the bloated state of capital markets the Fed actually has no choice at all. It will have to support growth even if it means higher inflation.

Inflation is the inevitable albeit lagged consequence of printing money. As inflation slowly marches higher, as a dovish Fed holds down yields at the short end and as financial repression holds yields down at the long end real yields must fall, not rise. And that in turn marks the start of the USD’s long-awaited U-turn. When does inflation show up? Best guess: late 2016, provided that the markets do not crash due to sudden loss of confidence in the Fed or a recession in the real economy. Between now and then range-bound USD is more likely than the surging USD of the last four years.


The country’s fiscal woes continued in August with tax collections down 9.3% yoy. However, part of the misery was due to statistical reasons. Significant one-off revenues were recorded in August 2014. The failure to repeat such measures this year meant that the base of comparison was less than flattering. Even so, the underlying pace of contraction in tax revenues – due to the ongoing economic recession – remains close to -4% yoy, which is weaker than GDP growth. Core retail sales declined 1.0% mom in July, or 3.5% yoy.

The greater collapse in tax revenues than the economy as a whole illustrates the pro-cyclical nature of the fiscal initiatives introduced under former Finance Minister Guido Mantega. The government is seeking to change this unfortunate state of affairs in its 2016 Budget, which proposes measures to achieve a primary surplus of 0.5% of GDP, but some three quarters of the measures required to reach this goal require parliamentary approval. Sadly for the government, things are not looking too hopeful.

The impeachment process against President Dilma Rousseff has now formally begun. This does not mean, however, that the process will reach its conclusion. The process requires approval by 2/3 of members of both the Lower House and the Senate and could take months.

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