Monday Musings: August 31, 2020

Aug 31, 2020


Public Trust Credit Team
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Chairman Powell makes the case for the Fed’s new average inflation policy of 2% in what many see as a more dovish strategy going forward

Set by the Federal Open Market Committee (FOMC), the Fed operates a model (mandated by Congress) that is collectively known as its “dual mandate,” targeting price stability and maximum sustainable employment. Regarding maximum sustainable employment, the Fed recognizes that a multitude of factors impact the structure of the labor market so articulating an explicit target would not necessarily be prudent; as a result, the FOMC’s decisions incorporates a vast array of labor market indicators, and an exact quantitative figure does not come into play. Concerning price stability, the Fed has been much more specific with a target rate of 2% inflation. Historically, the FOMC used the 2% calculated annual change in the Price Index for Personal Consumption Expenditures (PCE) as its gauge for its target inflation. Here is where the deviation and new plan comes to light.
Chairman Powell’s recent speech (New Economic Challenges and the Fed’s Monetary Policy Review) at the Jackson Hole meeting outlined the Fed’s planned changes to the target inflation rate. The strong labor market after the Great Financial Crisis never triggered a meaningful uptick in inflation. Inflation remained muted considering how well the labor market improved, which Powell refers to as “flattening of the Phillips curve,” and further drove down inflation. Essentially, persistently low inflation can drive long-term expectations of inflation lower in turn driving actual inflation lower. At its core, expectations for low inflation become self-fulfilling and manifest lower actual inflation outcomes. Combined with Chairman Powell’s observation that “expected inflation feeds directly into the general level of interest rates,” the notion that lower expected inflation will adversely impact the level of interest rates becomes a key argument for the new average interest rate strategy. Principally, the lower bound of interest rates limits the central bank’s ability to cut interest rates as needed during an economic downturn to stabilize the economy.
In examining the new average inflation policy, we can see that during a time frame when the inflation rate is below 2%, the Fed’s new appropriate monetary policy will seek to counterbalance this deficit by attempting to target an inflation rate above 2% for an undetermined amount of time. The Fed is not producing a set parameter or mathematical calculation that defines the average, making it a flexible form of averaging and a more holistic approach. Gone are the days when the Fed would proactively tighten or increase interest rates to stave off spikes in inflation. Some market participants find this new approach as sending a more dovish tone, providing the foundation to keep interest rates at or near zero for a longer time. 

Canadian banks Q3 2020 earnings highlights

Last week, the six largest Canadian banks reported their earnings ended July 31, 2020. The largest banks continue to benefit from highly diversified business models that have proven resilient in the face of COVID-19 headwinds. As expected, capital market related results were particularly strong this quarter, nicely benefiting the largest players. Meanwhile, the low interest rate environment added pressure on net interest income and the uncertain economic outlook forced Canadian banks to continue building their provisions for credit losses. Overall, performance was better on a sequential basis as a result of moderating loan loss provisions following the material spike in the second quarter, and the six banks remained profitable. The unprecedented level of government support and deferrals that have taken place continue to help banks’ asset quality metrics with many industry analysts expecting the peak of loan impairments to occur in 2021. Capital and liquidity levels remain solid across the board, a strong credit positive for the Canadian banking sector. While a lot of uncertainty remains on the horizon, particularly around the pace economic recovery, the consensus view remains that quarterly provisions for loan losses should have already peaked, helping the bottom line going forward but profitability is unlikely to return to pre-pandemic levels anytime soon.

Citing concerning health issues, Japanese Prime Minister Shinzo Abe announces resignation

Shinzo Abe, Japan’s longest serving Prime Minister (PM) and leader of the country’s Liberal Democratic Party, is expected to remain in office until a new party leader is formally approved by the Japanese parliament. His third term expires in September 2021. Party leaders are currently discussing an emergency vote by the middle of next month to determine Abe’s successor. Abe was appointed as Japan’s PM in December of 2012 and is widely recognized for his economic strategy (commonly referred to as “Abenomics”) centered around monetary easing, large government stimulus packages, and structural reform initiatives designed to improve competitiveness, corporate governance, and labor market conditions. While Japan maintains its position as an export powerhouse and unemployment remains extremely low, many have criticized Abe’s policies as structural reforms to improve the ease of doing business, saying they have made only limited progress. The Bank of Japan’s ultra-loose monetary policy has failed to spur any inflation, and the government’s debt burden as a percentage of GDP is now the largest among developed countries. With the COVID-19 pandemic exacerbating Japan’s already weak trends in private consumption, Abe’s successor will look to continue to ensure that markets, businesses, and consumers are well supported, meaning any immediate or radial changes to Japan’s current economic policies are unlikely in the near-term. As of now, there are no clear-cut candidates to replace Abe as PM, though ex-foreign minister Fumio Kishida and former defense minister Shigeru Ishiba have been rumored as two potential front runners.
All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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