Strong U.S. Earnings and Capex, Central Bank Divisions, and Shifting Inflation Assessments

Divided central banks and differing policy rate outlooks

Last week brought unchanged policy rates for the Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE), Bank of Japan (BoJ), and Bank of Canada (BoC). Brazil’s Banco Central do Brazil (BCB) cut rates but highlighted firmer underlying inflation and stronger growth, which implies a risk to expectations for potential future easing. Both the ECB and BoE stated an intention to be attentive to second-round effects on prices from oil, or the pass-through of high energy prices in underlying inflation. The BoE noted the risks to the economic outlook and the tightening in financial conditions. The ECB cited upside risks to inflation but also intensifying downside risks to growth. Nonetheless, markets imply high odds of rate hikes in June by the ECB.

The BoJ delivered a hawkish hold, suggesting policymakers are leaning toward a June rate hike. The BoJ lowered its growth forecast but raised projections for both overall and core inflation with pass-through expected given “a labor shortage continuing to be strong.” The BoJ also described its inflation forecast as being “significantly higher.” The vote to leave rates unchanged was six-to-three, with all three dissenters voting for a hike. BoJ Governor Kazuo Ueda told reporters after the vote: “as chair, I take that seriously.” This was the highest number of dissents at a BoJ policy meeting in ten years.

Similarly at the Fed, there were four dissenting votes, the highest since 1992. One dissenter argued for a rate cut, while three voters did not support inclusion of an easing bias at this time.²

At the previous Federal Open Market Committee (FOMC) meeting in March, Fed Chair Jerome Powell suggested, “some participants judged that there was a strong case for a two-sided description of the Committee’s future interest rate decisions in the post-meeting statement.” He added there were even more participants wanting two-sided guidance this week. Powell and other colleagues may have been concerned that two-sided guidance would start the process of markets pricing in Fed rate hikes, which does not appear to be the guidance most policymakers are ready to deliver at this point.

On his future, Powell said last week’s press conference was his last as chair, but he will continue to serve as a governor, “for a period of time, to be determined.”

Bottom line: The Middle East conflict prompted a sharp repricing of global policy rate outlooks. Interest rate futures markets initially placed high odds on April rate hikes by the ECB and BoE, which we felt were highly unlikely. Meanwhile, markets priced out Fed rate cuts, an appropriate adjustment to pricing given inflation risks from higher energy prices. Rate decisions going forward will likely be determined by policymakers’ judgement of the risks to inflation and growth.

A leadership change at the Fed may revamp inflation assessment methods

In his confirmation hearing, Fed Chair nominee Kevin Warsh advocated for the use of “trimmed mean” inflation measures³, presumably in place of the “core” inflation measures currently emphasized by many policymakers. Core inflation in the U.S. excludes food and energy prices. With trimmed mean inflation, changes for individual components of the price index are ranked, and parts of the most extreme observations at both ends of the range are excluded to better capture the central trend. Trimmed mean Personal Consumption Expenditures (PCE) inflation is reported by the Federal Reserve Bank of Dallas.

Trimmed mean measures of inflation may be preferable to “core” measures, as they exclude outliers dynamically, rather than excluding food and energy every month (or energy and unprocessed food in the Eurozone; energy, food, alcoholic beverages and tobacco in the U.K.; and fresh foods in Japan). While other regions also report trimmed mean inflation rates, these metrics are generally not a central focus for policymakers outside Canada, but even there the Consumer Price Index (CPI)-trim measure has been somewhat de-emphasized recently by the BoC. Nonetheless, closer attention from the Fed might stimulate greater emphasis by other central banks.

Trimmed mean inflation measures have their detractors, who point to these indicators being slow to signal rising inflation pressures resulting from COVID⁴ and the government’s response to the pandemic, in part because it trims the high-price components more than the low-price components.⁵

This chart shows the measure of core inflation that filters out extreme price movements (outliers) from the overall PCE data since 2015.

We utilize a 20% symmetrical trimmed mean inflation scale, which seeks to improve on the Dallas Fed measure using three methods. First, it excludes 20% of the outliers on both ends of the spectrum (Figure 2). Second, it focuses on the momentum of price gains by tracking three-month and six-month inflation rates, in addition to year-over-year gains. Third, it assesses the breadth of rapid price gains based on the share of PCE components reporting one-month annualized gains faster than 5%.

Bottom line: Symmetric trimmed mean inflation, and measures of the momentum and breadth of price increases may gain traction at the Fed and other central banks as tools to assess underlying inflation trends. Our assessment of underlying inflation is less favorable than that indicated by the Dallas Fed trimmed mean measure, supporting our preference to remain underweight duration.