The Fed can't afford Christmas presents

The Federal Reserve has ceaselessly continued the tightening of its monetary policy which started in 2015. Last week the Fed hiked its target rate to 2.125 percent.

The Fed is widely expected to continue hiking with 0.25 percentage points in its December meeting, and further on three or four times more next year. This time, the Fed can’t afford Christmas presents with pausing the hikes.

The good performance of the American economy has now lasted record long and some overheating is seen in parts of the economy. Unemployment has fallen to 3.8 percent – the same level as before the change of millennium. Before that, unemployment wasn’t as low since the 1960’s.

The tightening labour market, rising private consumption and import price pressures increase the risk of inflation. Consumer prices are now rising at an annual pace of 2.7 percent. Thanks to president Trump, the fiscal policy is loose, so the economy is running fast.

There are some warning signals as well. One of the most followed by the markets is the steepness of the yield curve. Short rates have risen more than long rates. The difference is now close to zero, which has previously indicated a turn in the economy and even recession in some cases.

Economists expect widely the US economy to soften only in 2020. But expectations of slowdowns can be self-fulfilling: when confidence decreases, consumption is reduced and investments are postponed. The upcoming turnaround impacts the monetary policy eventually.

If the central bank would envision such a scenario, it could keep rate hikes on hold. That would be a positive surprise for the markets and the economy. Equity prices would get a nice boost and the yield curve might not get negative. The flip-side of such a decision would be an eventual overheating of the economy, so the Fed will probably pass this opportunity for the moment.

The climbing dollar rates imply higher financing costs for everyone funding in dollars. By now, the higher yields have strained many indebted emerging economies. Higher dollar yields are also forcing out rate hikes in countries that are prone to capital outflows. Unfortunately, no relief is in sight for them.

Rising financing costs has previously led in the US to rising delinquencies and defaults with a lag of one to two years. The problems pile up to highly leveraged and fast growing companies. Conditions get tougher for them.

There might be signs of an economic turn in the US, but forecasting a recession is still premature. Looking at the economic conditions here and now, the Fed’s current policy is well warranted.

 

Text: Tomas Hildebrandt

Tomas Hildebrandt is a senior portfolio manager for institutional clients. He is a member of Evli’s asset allocation team and is also working as a market strategist. Tomas joined Evli in 1996 and has been working in capital markets for nearly 30 years.

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The opinions expressed in this article are the author's own and do not reflect the view of Evli Bank.

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