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Fed's Tightening Path Will Continue to Strengthen Dollar

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By Friday, 09 November 2018 09:48 AM Current | Bio | Archive

Central banks are becoming almost boringly predictable, at least on the short-term monetary policy outlook.

The Federal Reserve statement Thursday was utterly predictable. Markets are expecting a December rate hike because the Fed is going to hike rates in December. Markets are expecting further rate hikes in 2019 because the Fed should be doing further rate hikes in 2019. We know this.

The Fed’s Federal Open Market Committee (FOMC) statement reads: “The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced.”

Among investors, many asked themselves why we saw the dollar strengthen after the FOMC statement was released.

In my opinion, one of the main reasons is that the Fed is the only “important” central bank that remains on its path of rate increases as well as quantitative tightening, which of course is not the case for the European Central Bank (ECB), neither the Bank of Japan (BoJ), nor the Bank of England (BoE).

Investors could do well keeping this situation in mind when making investment decisions.

That said, we should also not overlook the fact that the Fed’s current policy is still very accommodative, and it would be “loco” not to do something.

The only real uncertainty is where the rate hikes stop, and that is in part because central bank policy isn't just about interest rates. Quantitative policy, or bond buying, is also part of the mix, and as the Fed is adjusting its balance sheet already, the decision is essentially around lower rates and a lower balance sheet or higher rates and a higher balance sheet.

It is the U.S. economy that will define the Fed’s path, which means that the Fed should be continuing to tighten, at least for the time being, which is a positive for the dollar.

Pricing pressures arise from the tightening labor market and to some extend from the trade tariffs increases, although those are a shorter-term risk for prices.

U.S. Producer Price Index

The producer price index for final demand advanced 0.6 percent in October; services increased 0.7 percent, goods rose 0.6 percent.

Final demand goods: The index for final demand goods climbed 0.6 percent in October, the largest rise since advancing 0.9 percent in May. Nearly three-fourths of the October increase can be traced to prices for final demand energy, which moved up 2.7 percent. The index for final demand foods rose 1.0 percent. Prices for final demand goods less foods and energy were unchanged.

Yes, the Fed will continue its tightening path in order to control inflation in 2020.

Producer prices signal corporate pricing power because companies sell to other companies for the most part. It will also capture some of the effects of the trade tariffs filtering into the U.S. supply chains.

China’s Inflation Data

China's consumer price inflation (CPI) remained at 2.5 percent year-on-year (y/y) in October and remained at its highest level in seven months. On a monthly basis, consumer prices went up 0.2 percent in October, after a 0.7 percent rise in a month earlier and in line with market expectations. It was the lowest monthly figure since a decline in June.

The producer price index (PPI) in China increased by 3.3 percent y/y in October 2018, after rising 3.6 percent in September. It was the lowest reading since March. On a monthly basis, PPI went up 0.4 percent.

UK Third Quarter GDP

The UK third quarter GDP expanded by 0.6 percent, in line with market expectations. Quarterly GDP grew at its fastest rate since the fourth quarter of 2016.

Business investment has been softer, although there are structural problems in capturing business investment in the UK in particular with the significant increase in self-employment lowering the distinction between what is investment and what is consumption.

Investors could do well keeping in mind that if a UK-EU divorce deal is done, which I still believe it will be done, the British pound could see a relative quick and nonnegligible appreciation.

To put this in context, on June 24, 2016, the day after a majority of 52 percent of British voters supported leaving the EU in a referendum, 1 British pound (GBP) cost about $1.486 dollar. Today it’s about $1.30 dollar per GBP or a difference of about 14 percent.

Etienne "Hans" Parisis is a bank economist who has advised investors on financial markets and international investments.

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Central banks are becoming almost boringly predictable, at least on the short-term monetary policy outlook.
fed, central bank, rates
Friday, 09 November 2018 09:48 AM
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