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Trying to Understand How the Fed Thinks

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Thursday, 27 December 2018 09:51 AM Current | Bio | Archive

For investors, it’s important to keep in mind that the Federal Reserve is only interested in how market prices impact the economy, the unemployment rate and inflation.

So, if the markets have turbulent moments, the Fed isn't there to ease the markets’ pain. The Fed is there to follow monetary policy in order to best achieve its twin objectives: sustainable low employment, and price stability.

The Fed has “eased” a little bit and scaled back its estimated 3 rate hikes in 2019 to 2 as its “median” estimate.

Fed Chair Jerome Powell talked in his latest news conference also about the tightening of financial conditions. He also said the financial tightening has to be significant and long-lasting to have a real effect on the economy. 

At the end of the day, the key questions are: What’s the Fed’s outlook for growth? What are the consequences from that outlook for growth on unemployment? What are the consequences of the kind of unemployment for wages and prices?

Now, what the Fed is saying in its forecasts is that it still thinks that despite the turbulent stock market and despite the slowdown in global growth, the U.S. economy is still set to grow at an “above” trend pace in 2019, and that’s why it continues to tighten. 

Now, it’s also a fact that the Fed looks at the stock market and financial conditions broadly, but it also looks at economic news like for example what’s happening to payroll employment.

Keep in mind that the Fed needs to see payroll employment gains of about 100,000 a month to stabilize the unemployment rate and they now see gains of much greater than that.

Unsurprisingly, the Fed’s view is that the economy is growing “above” trend pace. We have a very tight labor market. We need to slow the economy down. Therefore, somewhat tighter conditions aren’t really a bad thing. In fact, they are a necessary thing for the Fed to achieve its objectives. 

Taking all that into account, I think next year we could see 2 or 3 rate hikes while, of course, all depends on the economy and how the outlook changes.

So, in case the stock market would keep going down and the economy starts to weaken, there is no doubt that the Fed would take a “pause.”

There is also no doubt that we have entered a more volatile period while investors should keep in mind that the Fed’s “primary tool” is still short term interest rates. Now, in case the balance sheet runoff would have more impact on financial conditions, and that will affect how much the Fed actually tightens. I still think that the only way the Fed could stop the runoff is that the economy gets so “soft” that they have to cut short term rates. As long as the Fed is on hold or on tightening we should expect the balance sheet runoff to continue.     

The question that is out there is if a 2.40 percent Fed funds rate is too tight in a 2.0 percent inflation world?

In my view that is not a too tight Fed policy.

Meanwhile, investors should remain aware that we’ll have very “thin” trading until January 7.

Besides that, Reuters reported that China has proposed a ban on forced technology transfer and illegal government “interference” in foreign business operations, practices that have come under the spotlight in a trade dispute with the United States. A draft foreign investment law was published by the top legislature yesterday and comes as China tries to resolve its protracted standoff with the United States, which accuses it of unfair trade practices including intellectual property (IP) theft and forced IP transfer.

Once adopted, the law will replace three existing ones that regulate joint ventures and wholly foreign-owned enterprises, although it will likely go through several readings before being submitted for formal approval, which could take another year or more.

Nevertheless, this is a positive development that comes just before a U.S. trade delegation visit to China that has been confirmed for the week of January 7, CNBC reported.

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

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For investors, it’s important to keep in mind that the Federal Reserve doesn’t care about market prices for themselves. The Fed is only interested in how market prices impact the economy, the unemployment rate and inflation.
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Thursday, 27 December 2018 09:51 AM
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