UBS On-Air: Paul Donovan Daily Audio 'The Fed – mime versus meme'

Paul Donovan · UBS Global Wealth Management

Current US inflation is a temporary supply-shock episode that will fade within a year, not a continuous inflation problem.

The Fed faces an inflation episode driven by supply shocks, which it cannot control. Donovan calls it a temporary problem that will fade within a year of starting, so policy could not have a meaningful impact on prices in the wider economy before it fades. The appearance of continuous inflation comes from the fourth one-off shock in a row. He argues that a continuous episode would mean prices that rose last year rise again this year and next, and that is not what is happening.

“The Fed's problem is that they are facing a supply shock driven inflation episode over which they have no control. It is a temporary inflation problem which will fade within a year of its starting”at 0:40

Paul Donovan · UBS Global Wealth Management

US households' inflation perceptions are irrational and drive an affordability crisis that logic won't change.

Donovan argues that consumers are not rational about inflation. Few ordinary US households understand what the Fed is or does. Because of the affordability crisis, which he ties to inflation perceptions, people are unlikely to respond to logical explanations. He uses this to explain why the Fed's communication is so hard, not just poor.

“Consumers are not rational when it comes to inflation perceptions. Few ordinary US households understand what the Fed is or does. And in the face of an affordability crisis driven by inflation perceptions, they're unlikely to listen to logic.”at 1:28

Paul Donovan · UBS Global Wealth Management

Investors are unlikely to bet heavily on a near-term renewal of the Gulf War after the US midterms.

The Wall Street Journal has reported that the US is warning Gulf countries of a possible short but intense renewal of the Gulf War after the US midterm elections. Donovan expects markets to price in the idea of escalation. Given past performance, he thinks few investors will bet on the short duration described with much conviction.

“Markets will take into account the idea of an escalation of the conflict. Given past performance, it is unlikely that many investors will choose to bet on the short part of the description with much conviction.”at 2:58

Paul Donovan · UBS Global Wealth Management

Israel's inconclusive election leaves Netanyahu as temporary PM, keeping control of the military until a result.

Israel's general election has produced no decisive result, because neither Netanyahu's coalition nor the opposition can form a clear majority. Donovan notes that exit polls are not wholly reliable in Israel and that the seat count is likely to shift. He concludes that Netanyahu will stay on as temporary prime minister, and so in control of the military, until a definite political outcome emerges.

“It suggests that Netanyahu will remain as temporary prime minister and thus in control of the military forces until a definite political outcome emerges.”at 3:55

Paul Donovan · UBS Global Wealth Management

Fed's rate rises to the top of neutral are performative signalling that leaves the growth outlook unaffected.

The Fed talks tough and raises rates to the top of the neutral range. Donovan calls these gesture rate rises, a performative act that signals action and lets the Fed take credit when inflation falls on its own. Because policy stays within the neutral range, he argues the growth outlook should not be affected, and the inflation outlook is unaffected too. He flags two risks. The first is that the Fed misjudges where neutral is, which he says has to be considered given the quality of US labor force data. The second is that markets read the hawkishness as a sign of tightening into an oil shock.

“The Fed's response seems to be to talk tough while raising rates to the top of the neutral range. Gesture rate rises, a form of performative art.”at 1:44

Paul Donovan · UBS Global Wealth Management

Markets may read Fed hawkishness as a response to an oil shock, risking recession in the non-oil economy.

Donovan sees a risk in how markets interpret the Fed's hawkish stance. If investors take it as a sign the Fed intends to counter an oil shock with restrictive policy, the result could be a recession in the non-oil economy. He notes that bond investors have been flirting with this scenario, though equity investors have not.

“that the markets take the hawkishness as a sign that the Fed intends to counter an oil shock with a repressive policy and a recession in the non oil economy, a scenario bond investors, though not equity investors, have been flirting with.”at 2:28

Paul Donovan · UBS Global Wealth Management

The Gulf war's reported $47 billion cost adds roughly 0.15% of GDP to the US federal deficit.

Media reports put the cost of the war to the US at $47 billion. Donovan works through the implication for the federal deficit and estimates that the war adds about 0.15% of GDP to it. He uses the reported cost to size the fiscal impact of the conflict.

“Separate media reports suggest that the war has now cost $47,000,000,000 for The United States, which implies an additional to the addition to the federal deficit of about 0.15% of GDP.”at 3:13