As widely expected, the Fed decided to leave the key policy rate unchanged, but did signal that the general economic picture was improving. What does this mean for interest rates, the USD, and stocks going forward? Read to know!
The Fed conducts its policy by "juggling" with several aspects of the economy. Here are a few it must keep in mind:
There are MANY others. In a nutshell, the Fed wants to avoid the need for a fast increase of the policy rate, because this tends to stress credit markets. It builds scenarios based on information that is known at the time of the decision for the rate, as well as the planned path of its policy rate. If the economy is displaying strong growth momentum and is close to "potential production", the Fed starts to "put on the breaks" (increase the Fed Funds rate) to avoid overheating down the road. The US economy right now seems to be close to or perhaps slightly below potential. This can be seen by the unemployment rate (which is low, suggesting a tight labor market), the quit rate, which is a proxy for how confident workers are about job prospects, the employment rate (which tanked in 2008-2009 and has yet to fully recover) and the participation rate (same story as the employment rate).
To assess inflation and potential for future inflation, the central bank looks at several measures of inflation, but the most important one is core PCE inflation rate, which the Fed targets for 2%. Current core PCE inflation is at 1.6% and finally rising towards 2%. After a long period of stagnation, wages are also starting to rise a bit, which the Fed keeps an eye on because of the possible effect on future inflation. The Fed also follows inflation expectations, which are still a bit low, but rising. This all suggessts there is limited inflation pressure, but a need to "put on the brakes" softly, which is indeed signalled by the Fed and priced in by the market: approx 2 extra moves by the Fed for 2017 - nothing too big.
Now the big unknown is Trump policies. If President Trump and his party decrease taxes AND adopt a program of infrastructure spending, that would ADD to production and jobs going forward, and that would prompt additional tightening by the Fed. The Fed is thus waiting to get a clear picture of the extent of "fiscal and government spending stimulus" the economy will get, which is why it is keeping a neutral tone for now.
The Fed, Trump, and the USD
Generally speaking, a tightening policy (hawkish) appreciates the currency and a loosening policy (dovish) depreciates the currency. The USD is currently historically quite "strong" versus many other currencies. Here is the value of the USD versus many trading partners (up is appreciation), first in the longer picture of 2000-2017 and then the last 12 months:
The last time the USD was this strong was in early 2000s, about 15 years ago. The USD is generally strong and Trump actually complains about this because it is (indeed) detrimental to US exporters and the USA needs to bring the current account in less negative territory, because it is accumulating debt towards the rest of the world at an unsustainable pace, as explained in my last post. A fiscal expansion would pump the USD up even more, so unless Trump forces the Fed to keep a loose policy (not a chance in Hell Trump will tell the Fed what to do), he will complain even more.
Japan and China have historically printed their own currencies and flooded the market to depreciate them. China stopped doing this recently, but Japan did it quite a bit up until recently. These past or current manipulations have caused warnings from the US to "currency manipulators." However, the currency manipulators buy US debt (they print their currency and buy US bonds), and that helps the USA finance the debt and keeps bond prices higher than they otherwise would be, hence interest rates lower than they otherwise would be. The Fed knows this and juggles with this issue as well in the conduct of its policy.
Now if Trump and the Republican party embark on fiscal expansion (tax cuts and infrastructure spending), expect more rate hikes and USD appreciation. If this does NOT materialize, expect the USD to probably weaken, unless growth, jobs, and inflation really surprize in the coming months.
The USD is currently supported by rumors of Fed tightening and of government spending and tax cuts, but ALL these elements could wane if the economy shows a bit of slowing and if Trump does not deliver a convincing spending and tax cut program that is massive enough to feed production, jobs, and inflation in the short run.
Lots of uncertainty indeed. Fow now, Trump has been putting emphasis on ridiculous and controversial issues: a wall with Mexico, travel bans for Muslims, an abortion law, and trade war menaces. All this is NOT bullish on growth. Now if this continues, the USD will likely run out of steam. If talks of massive spending and tax cuts resurface, then perhaps the USD can appreciate more... otherwise, all the priced in growth and monetary tightening will wane and the usd will depreciate, which indeed started since the New Year... Like and share if you liked!