Re-thinking the target

As we head towards the Federal Reserve’s last monetary policy meeting of the year, it’s worth reminding ourselves of past mistakes and future challenges faced by the US central bank. A year ago, in December 2018, the Fed hiked interest rates by 25 basis points and despite softer expectations of growth and inflation, signalled further increases would be on the way in 2019. This was almost entirely at odds with the assumption of market participants that rates would be kept on hold and no further interest-rate hikes would occur in 2019. The decision also incurred the wrath of President Trump who criticized the Fed for hampering the US’ ability to compete on the global trade front. Amidst the backdrop of frosty US-China trade developments, the ensuing six-month battle between the Fed and markets wasn’t pretty and ultimately, the Fed caved with the first of three interest rate cuts in July 2019; their first cut in a decade.

Now that we’ve achieved some state of equilibrium, where central bankers have indicated a pause to interest rate changes and bond markets have calmed down, it is worth considering the current state of the US economy and what the Fed can do to try and combat subdued inflation expectations. As evidenced in recent months, a stronger US labour market hasn’t led to the kind of upward inflationary pressures that the Fed would have wanted or expected. Going further, the nagging inability to achieve their 2% target has contributed to declining inflation expectations and led to comparisons with the downward drift experienced by both Japan and Europe that has been notoriously difficult to reverse. The above could result in the Fed adopting a dovish shift to interest-rate policy, without a need to alter the benchmark rate.

In his October 31st press conference, Fed chair Jerome Powell commented that the Fed were thinking about more credible ways of achieving their inflation target by averaging 2% over a specified time period. This would give them the freedom to keep rates lower for longer, even if inflation rises above the target rate in the short term, and the average rate remained below 2%. Looking at the potential impact of this policy during the next recession, the Fed would neither be eager or pressured to raise rates too soon, allowing the economy to embark unhindered in its recovery. It may not be long before the Fed deems it necessary to implement such a policy, the only question remains whether it’d be enough to combat the ‘Japanification’ of the US economy.

Bottom Line: Most, if not all, expect the Fed to pause their mini rate-cut cycle at next week’s meeting, so the focus will be on the language used in their statement and any hint on future policy during Powell’s press conference. It’s true that in recent weeks there has been an improvement in the balance of risks to the global economic outlook, but the Fed are more likely to focus on their pesky inflation problem in the near-term.

The week ahead

GBP

With less than two weeks until the general election, the trade-weighted Sterling index continues to gradually drift higher, while its trading range against the US Dollar is narrowing, suggesting a sharp break out of the range is getting closer. A quiet week ahead for economic data could mean calm trading conditions as markets digest updated election poll releases.

  • UK Final Services PMI will be released on Wednesday morning, providing a health check on the UK’s most dominant sector. Expectations are a sharp contraction of 48.6 which would be the weakest reading since August 2016.

USD

Last week, the trade-weighted Dollar index found support at the 50-daily moving average, meaning the index closed November above all three of the major daily moving averages (50, 100 and 200). This could prompt significant USD strength as we enter year end. Federal Open Market Committee (FOMC) member Quarles will be speaking on Wednesday and Thursday afternoon.

  • On Monday afternoon, ISM’s Manufacturing PMI is set to improve on last month’s, posting a marginal contraction at 49.2. If it reads as expected it’ll be the best in three months. A reading as expected would be the best in three months.
  • Wednesday will host the ADP Non-Farm Employment change which will provide an indication on what Friday’s payroll figure will be. It’s expected to show 140k jobs added to the US labour market.
  • Wednesday will also see the ISM’s Non-Manufacturing PMI release, which should show expansion for November at 54.5, slightly down from last month’s 54.7.
  • On Friday, labour market data will be released – Non-Farms are expected to post 189k new jobs in November, and month-on-month hourly earning are expected to post 0.3% growth.

EUR

The trade-weighted Euro index traded relatively flat last week, closing the week in the green following month-end Euro strength on Friday afternoon. The index continues to trade near year-to-date lows, with short-term resistance at the 50-daily moving average just 0.3% away. On Monday afternoon, Christine Lagarde will be speaking in Brussels.

  • This week’s data began on a positive note with European Manufacturing PMIs beating expectations across the board. Although still in negative territory on the aggregated Eurozone reading, the data points to a bottoming-out in Europe’s manufacturing sector.
  • Final Services PMI will be released on Wednesday morning and expectations are a 51.5 reading, continuing the six-year trend of expanding European services.
  • On Thursday, month-on-month Retail Sales for November are expected to show contraction at -0.4%, down from a previous expansion of 0.1%.