Will the Fed continue to hike rate aggressively?

Will the Fed continue to hike rate aggressively?

The stock market crashes, growing trade tensions with China, low growth forecasts from the IMF, and even Trump’s verbal attacks are likely to not be able to stop the “insane” Fed from further rate hikes. There is a serious reason for this – the development of the economy is still in accordance with the forecasts of the central bank.

Thursday inflation figures revealed a slowdown in price growth from 2.4% to 2.3%, which nevertheless remains near the target level of 2%. At the same time, the absence of inflationary pressure is accompanied by record-breaking low unemployment, which makes it possible to contain consumer inflation expectations around a long-term equilibrium. All historical periods of high employment were usually accompanied by an out-of-control inflation, which led to a recession. The fact that the economy is in “historically rare” conditions was said by Fed Chairman Powell in his last speech, which is the “core” of the aggressive plans of the regulator to tighten the policy. It is unlikely that the Fed has changed its mind in the last 48 hours, just on the basis of the pullback of the stock market, less upbeat IMF forecasts, and discontent from Trump, who called the Fed’s actions “crazy”.

It is curious that the market also does not believe that the Fed will abandon its plans: despite the correction, the probability of the December rate hike, according to the futures market, rose to 81.4% compared to 74.4% last week.

Gradual rate hike process up to 3% or higher next year may not allow the economy to grow at an impressive pace, but will take control of inflation, which leads the list of warning tokens before the crisis. On the eve of the 2008 recession, the prices had been growing at 6% pace; in previous periods of crises, the pace was also high.

Now when there is a choice between keeping expansion slower but long or impressive but short, Powell won’t repeat the mistakes of his predecessors and will subdue the risks of overheating now. One of them was, of course, the stock market, where the continuous flow of buyers put the rationality of growth in question. However, no one expected the Fed to slaughter the “sacred cow” in such a rough way.

In the presidential administration, not everyone shares Trump’s position regarding the Fed. Close Trump aide Larry Kudlow, when asked to comment on Trump’s comments said the central bank is “on target” and the possibility of a rate hike is a sign of “stable economy, which should be welcomed than feared”.

Robust hiring in the United States has narrowed the jobless rate to unprecedented levels in the last 50 years. In September, unemployment fell to 3.7% while wages rose by 2.8% in annual terms. The inflation rate of 2.3% means that the growth of real incomes has accelerated, which could give an additional impetus to consumption.

The correction in the stock market led to a reversal of the yield curve, which took alarming shape due to the diverging views of the market and the Fed regarding the pace of rate hikes. A part of investors from the stock market flew to short-term Treasury bonds, so the spread began to grow again. The short-term cost of borrowing thus began to change in a more favorable direction:

The only cause of concern remains the “welfare effect”, which adversely affects household incomes in the event of a fall in the stock market, as their assets depreciate. Accordingly, a long-term bear market in shares can stifle consumer optimism and business confidence, risking turning firms and households to the “savings” mode.

Major US stock indexes closed in the red on Thursday, the S&P 500 broke the 200-day moving average down, which is slightly worse than the situation in February, when the technical level effectively kept the fall. Nevertheless, the current pullback is not something extraordinary, since the history is full of 5% corrections during the expansion leg.

Today, data on export and import prices in the US, as well as consumer confidence from W. Michigan, are due to release. The stock market is likely to cover shorts, which should be supported by positive outcomes in the data.

In my opinion, the market could be preparing for the New Year rally, as the rollback of the stock market initiated by the Fed is somewhat different from the decline during the recession. Therefore, if the economic data continues to give signals of steady growth, the market panic will be short-lived.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.

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