Shrinking Fed Exceptionalism

• Stimulus from China has encouraged sentiment, but not in the Euro area where plummeting PMIs and some surprisingly soft flash inflation releases weighed. The Fed’s dovishly priced extremes became less exceptional from both sides.
• Next week’s data could extend that as the Euro area HICP is tracking low while US pricing looks much more vulnerable to another fall in the unemployment rate. Policy decisions are only from Colombia and Poland, so Powell’s speech is the main event.

China supported risk sentiment this week by unleashing a more decisive stimulus package. Not that this rising tide floated all boats. Domestic economic data often matters more to expectations in the short term than distant developments with relatively indirect and uncertain transmission. So a drop in the Euro area’s PMIs weighed on expectations for the ECB despite the additional support to global demand from China’s easing. It was also contrary to the US rates move as investors pared back a little more of their extreme dovishness.

The PMI crash in the Euro area (and slowing in the UK) was also contrary to the broadly sustained rapid pace in the US, which remains in rude relative health near its highs. Price balances also increased as forceful monetary easing into resilient demand risks reflating inflationary pressures from a hoped-for soft landing into no landing. US unemployment’s slight trend rise may not require much easing to resolve (see Clashing PMI and Policy Spreads ). Next Friday’s payroll and unemployment data can provide a crucial update on that trend. Dovish pricing arguably presumes a rise, contrary to the consensus for no change, so another drop would provide the bigger shock.

Drops of the dovish variety came from France and Spain's inflation data, which undershot the September consensus by 0.4pp and 0.2pp, respectively. Our forecasts were a tenth closer on both counts, albeit in the other direction for Spain. The negatively correlated surprises for us partly cancel out at the euro area level, so we remain relatively dovish in forecasting a 0.4pp slowing to 1.8% y-o-y. The current consensus remains at 2% but may drift lower as economists digest the national releases. The ECB already pre-empted the possibility of a low outcome by flagging it as insufficient to trigger an October cut, given the likelihood of a rapid rebound.

The Fed will be relieved to see US core PCE inflation slow to 0.1% m-o-m after cutting by 50bp last week. Nonetheless, it relies on rates being far above their neutral setting despite no evidence for this tightness. Historical parallels to 1998 are mounting with the forceful start and conveniently timed political support. Continuing that scenario means an early pause and hikes returning in 2025. Brazil has tracked a year ahead of the Fed in the last hiking and cutting cycles. Its latest hike would also be consistent with the Fed repeating a policy reversal (see Forceful Fed Rhymes From 1998 ).

Rates markets must also contend with loose fiscal policy as crowding out effects regain relevance post-pandemic. Large fiscal deficits put upward pressure on interest rates, contrasting with the post-GFC liquidity trap narrative. Global capital markets can no longer mask crowding out because simultaneous fiscal deficits in major economies constrain the potentially offsetting capital flow. The UK is opting for state-led interventions, crowding out the private sector by design, while the US stimulates private investment via public spending initiatives (see Crowding Out Effects ).

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