Policymaker dilemmas April 4, 2011 Federal Reserve officials talk tough, but rate hikes unlikely to come soon

oon U.S. Treasury market uncertainty set to increase as government debt limit approaches European Central Bank on course to hike rates, but peripheral weakness risks more instability

With three months left until the Federal Reserve concludes its Treasury purchase program, there are already growing signs of dissent among regional officials. Assessing the next phase of Fed policy could prove unusually tricky. The task will already be made more complicated by the fact that the emergency policy rate is only one of the measures that will have to be reversed, but open disagreements will likely only confuse matters further. Most visible in recent statements have been the hawks. Minneapolis Fed President Narayana Kocherlakota has argued that rate hikes should outpace core inflation (which the Fed itself expects will increase by 0.5 percentage points this year), while James Bullard of the St. Louis Fed has gone as far as to suggest that QE2 might be terminated early. The headline figures from last week's U.S. employment report will have given them more encouragement. At 230,000, the number of jobs added in the private sector exceeded forecasts, while the unemployment rate fell to a two-year low of 8.8% in spite of a 160,000 month-on-month increase in the size of the labor force. It could well be the case that wage pressures begin to appear at a higher rate of unemployment in this cycle than they have in others. The average duration of unemployment is still far higher than it was even when the unemployment rate peaked at 10.8% in 1982. Mismatches between the skills demanded by employers and those offered by workers returning to the labor force are therefore likely to have risen the structural rate of unemployment may be higher. But ultimately, it will be the pace of wage increases itself that signals the tightness or looseness of job market conditions. And so far, it still appears premature to sound the alarm. Average hourly earnings are still decelerating on a trend basis and were flat in March. Some have pointed to the recent spike in consumer inflation expectations, but this is most likely a product of the rise in oil prices and bears little resemblance to price changes in the rest of the consumer basket (see Exhibit 1). Indeed the last time such a wide divergence occurred, the deflationary impact from higher oil eventually prevailed. And judging by breakeven inflation rates, bond investors do not seem to share the same concern as households over near-term inflation prospects. We expect that little has changed in the Fed's policy stance, something that should become clearer as more doves (including Chairman Bernanke himself) speak publicly over the next several days.

Of greater consequence for investors over the next several weeks is likely to be the U.S. fiscal debate. For the past month, congressional Republicans have been locked in a prisoner's dilemma with congressional Democrats over an extension of government funding for the remainder of the current

fiscal year. Democrats want only light budget reductions over the next six months; Republicans are pushing for sharper cuts. Failure to reach an agreement would result in the cessation of a number of government functions, which many polls suggest would reflect equally badly on both parties. Compromise would serve each side better. But this bout will only be a curtain-raiser for the real showdown over an increase in the federal government's $14.3 trillion debt ceiling, which is expected to be reached between mid-April and late-May. Failure to raise it would not instantly mean a government debt default as internal funds could be used as a temporary plug. But the stakes in this debate for global investors are much higher, and while fixed income markets have been fairly relaxed over the FY2011 budget resolution saga, the use of stopgap funding measures to keep the government from breaching its debt limit could spell more volatility for Treasuries. The European Central Bank has also faced its share of policy dilemmas since the start of the eurozone debt crisis, but it now seems almost certain to raise its refi rate by 25 bps when it meets on Thursday; futures markets are expecting a further 75 bps over the next 12 months. Several eurozone economies including Germany, the Netherlands and Austria have seen headline inflation breach the ECB's below but close to 2%' target over recent months, and even core inflation has moved above the limit in a handful of countries. Ireland's government bond market enjoyed a mini bounce last week as the 24 billion deemed necessary to recapitalize the country's banking sector after the release of its stress test results did not come as a major surprise. But financial conditions in the periphery are still far from stable. Portuguese government debt spreads have ballooned since the fall of the government and the national central bank has lowered its estimates for growth (arguably the most important variable for Portugal as it tries to regain access to public markets) in 2011 and 2012 by a total of 0.4 percentage points. In addition, Ireland will still need to negotiate a lower rate on its bailout funds, and even if it is offered the same 100bp concession as Greece, it will still be far away from a fiscally sustainable path. Meanwhile there were fresh downgrades for both Portugal and Ireland from Fitch and S&P last week. And though markets have given Spain more breathing room as it makes better progress than the others on fiscal consolidation and structural reform, its household sector will remain vulnerable to higher interest rates. Spanish household debt levels are among the highest in the eurozone; home ownership is over 80% and close to 90% of mortgages are variable rate. Despite having experienced the largest of the Western housing bubbles, Spanish home prices have fallen the least (see Exhibit 2). They have further to go. And a higher cost of borrowing will only upset the demand-supply balance further. By continuing to give troubled financial institutions direct access to its refinancing window, the ECB will hope to avoid destabilizing funding strains in the banking sector. But it will clearly be taking a gamble as it embarks on its hiking campaign.

Global equity markets were able to weather two major external shocks in the first quarter and there will be further tests in store over the coming weeks and months. But the ongoing supports from corporate earnings, valuations and (still in much of the world) policy should prevent them from succumbing. Seven quarters into the recovery, the global economy remains only a third of the way through the

length of a typical post-war expansion and historically, it has taken a major unforeseen event to bring the cycle to a premature end. But while this should mean further gains for markets, persistent uncertainty should make for a more finely-balanced tradeoff between risk and reward. David Kelly, Chief Market Strategist & Ehiwario Efeyini, Global Markets Strategist

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