UBS On-Air: Paul Donovan Daily Audio 'Sort of stagflation?'
The desk interprets the Federal Reserve's recent decisions as indicative of a cautious approach towards a potential stagflation scenario. Per the full note from Paul Donovan at UBS, the Fed left interest rates unchanged while revising down growth projections for the next three years, which are expected to lag behind the previous four years, while raising inflation expectations. As traders assess this outlook, they should consider that stagnation accompanied by rising inflation could create significant pressure within the FX markets, particularly for USD pairs. With limited high-impact data on the horizon, the market may react strongly to any shifts in rhetoric from Fed officials.
What the desk is arguing
The current economic landscape suggests a blend of stagnant growth and rising inflation, likening it to a stagflation scenario. According to Paul Donovan at UBS, the Fed's latest forecasts indicate a slower growth trajectory and elevated inflation expectations, which could drive volatility in currency markets. Higher inflation alongside stagnant growth complicates the economic environment and could lead to reactive fiscal policies.
The Fed's revisions reflect a broader view that tariffs are likely to exacerbate inflation initially while impeding growth later. Donovan mentions that the Fed's cautious stance and the slower unwinding of its balance sheet highlight a need for market vigilance regarding liquidity dynamics.
The alternative perspective—considering a more stable economic outlook—seems less probable given the current governmental fiscal unpredictability and trade tensions.
Where it sits in our coverage
Our consensus view places the Euros versus the Dollar at a target of 1.075, with a range spanning from 1.04 to 1.12. Specific targets include: - jpmorgan: 1.10 by Mar26 - bofa: 1.04 by Mar26
This desk's call aligns closely with jpmorgan, suggesting buoyancy against the dollar, positioning slightly above the consensus midpoint, which indicates a cautious optimism despite the Fed's tightening narrative.
How other firms see it
Firms such as jpmorgan and others are aligned in expecting a weakening dollar under persistent volatility, while bofa appears to advocate a stronger dollar based on differing economic fundamentals.
Traders should monitor pairs like EUR/USD and USD/JPY, as shifts in central bank sentiment could impact these markets significantly.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01The Fed left interest rates unchanged, signaling caution amidst inflationary pressures.
- 02Revised forecasts show lower growth and higher inflation, prompting stagflation concerns.
- 03Market sentiment suggests volatility is likely in USD pairs given Fed policies.
- 04Traders should remain vigilant to shifts in Fed rhetoric and global trade dynamics.
Market implications
Watch for keyword signals from Fed officials regarding potential policy changes, as they could provoke movement in EUR/USD and USD/JPY. Currently, the focus is on maintaining levels around 1.075, which is critical to gauge future volatility.
Risks to this view
An unexpected shift towards a more aggressive rate-cutting stance from the Fed could invalidate the stagflation narrative and bolster the Dollar's strength, altering the projected trajectory of affected currency pairs.
Good morning. This is Paul Donovan, Chief Economist at GBS Global Wealth Management. It's 7 o'clock in the morning London time on Thursday the 20th of March.
The US Federal Reserve yesterday left policy unchanged to the surprise of absolutely no one. It also published a set of forecasts. Growth was revised lower for the next three years and the Fed's projections are that the economy will grow significantly slower than it has done over each of the last four years.
Inflation forecasts were also revised up for this year and next. Stagnating growth and higher inflation has the media twitching with barely concealed excitement and rushing to break out the stagflation headlines. Stagnant growth and higher inflation is stagflation but the word tends to give the impression of a return to Nixon-era levels of stress and that's just not fair now.
Tariffs will raise inflation first and lower growth second so it's not a very unusual set of forecasts. And of course the forecasts have to come with a considerable degree of uncertainty because the erratic nature of US government policy at the moment and the unpredictable nature of second round effects from those policies means that it would be foolish to claim any certainty for the economic outlook. US President Trump's response to this was that tariffs were a reason to cut interest rates which in their opinion the Fed should be doing.
This gives a clear but unsurprising signal of what will happen if the Fed loses its policy independence. Trade taxes can cause rate cuts if the focus is on the growth damage wrought by the tax increase and not the inflation wrought by the additional tax burden. The Federal Reserve did announce a change to quantitative policy.
The Fed will be reducing its balance sheet more slowly. Interpreting this requires care. The whole point of monetary economics is about the balance of liquidity demand and liquidity supply.
This is why we cannot say increasing money supply causes inflation. It's only when money supply exceeds money demand that you get that. The Fed has been responding recently to lower levels of money demand by reducing money supply or shrinking its balance sheet.
Now that money supply and money demand are more in balance, the Fed can afford to slow the pace with which money supply is being reduced without significantly changing the money supply money demand balance. This is not therefore really an easing of policy and should be regarded broadly as a stabilisation. UK's January labour market data comes with an official warning not to trust many of the statistics because no one fills in the labour force survey any more.
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