Economic Roundtable: Energy Shock & Central Banks’ Action

In this first of a two-part discussion, our Global Chief Economist Seth Carpenter leads a discussion with chief regional economists Michael Gapen, Jens Eisenschmidt and Chetan Ahya on impacts of the conflict in Iran and how central banks are responding.Read more insights from Morgan Stanley.----- Transcript -----Seth Carpenter: Welcome to Thoughts in the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist and Head of Macro Research. And today we're going to kick off our quarterly economic roundtable. And this is where we try to step back a little bit from the headlines and the day-to-day changes in markets and try to put the global picture together and frame it for you. In the first of this two-part discussion, we're going to cover the implications of the oil price shock for energy, inflation, and for central bank policy. As always, I'm joined by the Chief Regional Economists here at Morgan Stanley. I've got Michael Gapen, our Chief U.S. Economist, Chetan Ahya, our Chief Asia Economist, and Jens Eisenschmidt, our Chief Europe Economist. It's Tuesday, April 14th at 10am in New York. Jens Eisenschmidt: And 3pm in London. Chetan Ahya: And 10pm in Hong Kong. Seth Carpenter: So, let's just jump right into this. Over the past several weeks, global markets have been dominated by one story. The escalation, de-escalation, the news flow back and forth about the conflict in Iran and the ripple across energy markets, inflation, and growth. Our view has been that even if we don't see another huge leg up in the price of energy and another surge in volatility across financial markets, the persistence of the shock in terms of disrupted supply will be at least as important, if not more so for markets. So, let me start here in the U.S., Mike. You and I have each had lots of conversations with clients about how the Fed's going to react. Market pricing moved a lot before, has retraced, and now is kind of looking at no change in policy for this year, give or take. Your baseline remains that the Fed will have an easing bias and that we'll end up with a couple of cuts later this year. Can you walk us through that thinking, and also where the debate is with clients? Michael Gapen: Sure. So, the evidence in the data… This goes back, let's call it several decades now – that oil price shocks in the U.S. do tend to push headline inflation higher by definition. But they have very limited second round effects on core inflation. And the higher oil prices go, the more likely it is that you get some demand destruction, some weakness in spending, maybe even some weakness in hiring. So, there is a bit of a non-linearity here. In our baseline where oil is elevated, but let's say not excessively high, I can completely buy the argument that the Fed is on hold assessing the evolution of the data and wondering are there second round effects on inflation? Or is this weakening demand? So, Seth, our view is that the Fed is right in its assessment that tariff passed through to goods prices will eventually moderate. And that the oil price effect on headline will diminish. And later this year, core inflation moderates. That should open the door for the Fed to cut two times this year. I do think that the wrong thing to do in this situation is to raise rates into this… Seth Carpenter: I agree with you. Michael Gapen: Yeah. So, I think it's… The Fed's on hold or their cutting. If we're right on where inflation goes, that can open the door to cuts. But to your point, where is the investor debate right now? I think the knee jerk reaction from markets is – the Fed's on the sideline, for, let's call it the foreseeable future. Which as you noted in this market is day-to-day headline to headline. And the Fed will assess where to go later this year. We think they can cut. But I think in general, the Fed is either on hold or cutting. I think the wrong thing to do right now is raise rates. Jens Eisenschmidt: Yeah, let me jump in maybe here from Europe where in theory it's the same problem. Just that the answer that the central bank is likely to give in Europe is slightly different from the one in the U.S. So, the debate we have with clients is not so much about whether or not the ECB is going to hike rates. It's more about how much it will do or have to do this. I mean, again, it has a lot to do with the way oil prices in the end, end up trading. It will be a lot more inflation or less. But it has also to do with the way the mandates are constructed. So, the ECB really has a single inflation mandate and not a dual mandate like the Fed in the case of the U.S. So, there's much more attention on inflation. Next to that, we have stronger second round effects. Historically, we know that from the data. So, it's clear and understandable why ECB policy makers all came out cautioning against that inflation coming, and sort of mulling what had to be done there. We had some leaks out of the governing council ...