Aligning Incentives

Last week was dominated by the change in the Fed’s open-market committee members’ median forecasts for the policy rate. As such, bringing forward the Fed Funds lift-off to 2023 makes the trajectory more realistic as the market never believed the central bank’s previous trajectory in which policy rates would not change before 2024 (our own baseline has been two hikes in 2023 since the end of last year). What we focus on is the polarization of the FOMC across doves and hawks as the distribution of the members’ individual forecasts is widening. There are still doves who don’t want to contemplate hikes in the “policy relevant horizon” at all, and hawks who seem to get ready for a higher number of hikes. This polarization echoes the general debate on the possible fate of the current inflation spike. We remain in the “it’s transitory” cam”, which seems to still dominate at the Fed even if clearly some members are not inclined to take chances.

The market has responded to the new Fedspeak with a flattening of the US curve. We find this move itself understandable, but we remain puzzled by the level of yields at the very end of the curve, which we find low compared to the Fed’s median forecast for the “longer-term” Fed Funds rate. We reiterate our view that there is a plausible macroeconomic case for a rise in real rates in the US. We complement our argument by adding some considerations on supply and demand conditions on the US bond market in the next one or two years. US banks have raised their share in the ownership of US public debt, which for the recent period we attribute to the combination of a “deposit glut” which needs to be recycled and low demand for credit from the private sector. As the economy continues to reopen, we think this factor will fade, adding upward pressure to yields as the Fed tapers.

Last week we promised to extend our analysis of the G7 summit’s conclusions pertaining to the funding of the green transition in the less advanced economies. We were intrigued by Rhaguram Rajan’s proposal of a Global Carbon Incentive which would drive high CO2 emitters to curb their emissions and low emitters to keep them low. We have issues with the design of his formula – focusing on CO2 per head and ignoring CO2 per unit of GDP triggers all sort of adverse side effects – but his point on the potentially antagonistic interests of developed and less advanced economies when it comes to decarbonization holds. We think he dismisses carbon border taxes too easily as a solution, especially if the proceeds are recycled to fund transition projects in the South.