US/Brazil economic update (UBS panel at the IMF)
I was invited to speak on a panel hosted by UBS during IMF Spring meetings this along with IFF's Robin Brooks and Steve Kamin, who was head of the Federal Reserve's international division for many years (including during my time at the Central Bank of Brazil). As I usually do on these occasions, I wrote an event a script, which I share here.
Starting with the outlook for the United States economy, my reasoning framework since the beginning of the pandemic, the reason why I was already pessimistic about inflation at the beginning of 2021 (see my article in Valor Econômico, "Erro de diagnóstico", January 11, 2021), begins with the fact that the reaction to the pandemic shock involved an unprecedented coordination between monetary and fiscal policies. There was, for the first time since World War II, a huge transfer of fiscal resources to consumers, corporations, states and municipalities financed directly by the Fed via the purchase of Treasury bonds.
Recall that the post-GFC "QEs" were implemented in a period of fiscal tightening (in fact QE2 was a response by Bernanke to the precocious a politically motivated fiscal tightening initiated in 2010). Thus, the potency of QE was limited to changes in the term structure, flattening the yield curve, and some residual effect of portfolio substitution – that is, basically through the asset price channel, mainly helping the wealthy that have investments in financial markets. But from 2020 to 2022 we saw a version of Milton Friedman's "helicopter money drop," with Fed money going straight to the consumer.
Another way to understand the potency of what was done is to realize that, in this episode, the asset (money) was transferred to the private sector/households, but the liability (Treasuries) remained on the Fed's balance sheet (and, residually, in bank portfolios, which has recently become a problem for some institutions). Since there is in fact little "Ricardian equivalence" in practice (where the consumer takes into account the future tax liability of fiscal expansion), the only thing the consumer "saw" was his purchasing power increase.
Thus, we have the phenomenon of "excess savings", or excess liquidity in the balance sheet of consumers and companies. So though income flows are already running weaker (lower fiscal transfers and falling real wage growth), the still robust liquidity stocks allow consumption to continue even with high inflation and tight financial conditions.
But this dynamic has its days numbered, since the liquidity stock is falling, and so at some point aggregate demand will no longer have this important support (given the fact that this is something unprecedented, we must be humble and admit that we cannot know when the fall in excess liquidity will materially impact consumer behavior).
Profit margins remain high despite cost pressure; Companies can pass on to prices and the consumer can pay. Only when margins are impacted will core inflation cool via decreasing unit labor costs (i.e., higher productivity or less employment).
If we can understand recessions as a process and not an event, looking at the weakness already evident in some sectors, we can say that the recession has already begun, with the recent banking problems accelerating the process. Additional rate hikes aren't necessary, but given the huge misdiagnosis the Fed (and other central banks) made in 2020 and 2021 witht heir “transitory” thesis, it's not hard to understand their unwillingness to loosen policy quickly (central bankers are always fighting "the last lost war").
Is the market wrong to price in a rate cut later this year? No, for two reasons. First, there is still a concrete risk that other "non-linearities" such as recent banking problems will accelerate the recessionary process. Second, the current hawkish discourse is easy to sustain when the labor market is still very resilient. I have doubts in the current political environment (both in the U.S. and Brazil) that these various incarnations of Paul Volcker will be sustainable when the labor market strength cools considerably.
The process in Brazil is not at all different, but we have our "jabuticabas": an unresolved debate about the level of inflation target messing up market expectations; ongoing doubts about fiscal policy/sustainability (now not so much about the intention to make the adjustment, but about the ability to deliver and execute the announced new “arcabouço” by minister Haddad); and a still unresolved coexistence between a left-wing government and an autonomous central bank constituted by a right-wing government.
But it is undeniable that, compared to the risks of the beginning of the year, we are in a much better place on the fiscal question, which should lead the still inflexible Central Bank of Brazil to cut Selic soon. There is simply no technical argument for not calibrating the degree of monetary tightening dynamically as the disinflationary process consolidates over time.