The Fed Intimated Higher Rates Were Coming

A few weeks ago Fed Chairman Powell submitted his semiannual monetary policy report to Congress. Mr. Powell voiced there was still a need for gradual rate hikes, yet was adamant the economy was not overheating:

In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis … In the FOMC’s view, further gradual increases in the federal funds rate will best promote attainment of both of our objectives. As always, the path of monetary policy will depend on the economic outlook as informed by incoming data.

With record low interest rates for nearly a decade it is difficult to believe zero interest rates are not the new normal. “We need gradual rate hikes” and “We will remain data-dependent” sounded like double-talk. I assumed Powell was trying to talk down financial markets until inflation materialized. Some economists would rather see “the whites of inflation’s eyes” before hiking rates. Powell might decide differently Wednesday.

All About PCE

I expect Powell to also make a firm statement about the Fed’s mission. Over the past decade the Fed’s stated mission has been all over the place – insure against another Great Depression, create a wealth effect via stocks, spur personal consumption expenditures (“PCE”). I expect Powell to give a clear statement that the Fed’s mission is to spur PCE growth above 2 percent for a sustainable period. It was 1.7 percent in 2017 and has not reached 2 percent since Janet Yellen was first appointed Fed Chairwoman.

This likely means two to three rate hikes this year, and no additional hikes until PCE exceeds 2 percent for two to three consecutive quarters. Said another way, it’s could be now or never for Fed rate hikes.

Conclusion

How will the market react to a rate hike. Investors have gotten used to the melt up in stocks over the past decade. I expect analysts to continue to talk up financial markets, especially the potential M&A boost from the president’s tax cut. I recommend avoiding financial markets until the dust settles on the impact of rate hikes and the Fed’s balance sheet unwind.

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