The Fed's conundrum
The Federal Reserve is in the middle of an enormous conundrum. After promising three hikes in 2017 and committing to deliver them at the beginning of the year, the US economy has faced several impediments that has changed the view of various members of the Federal Open Market Committee members (FOMC).
High expectations of an aggressive fiscal expansion by the Trump Administration, and subsequent inflationary effects, encouraged the views of the FOMC officials on monetary policy normalization towards the end of 2016 and beginning of 2017, although this views have clearly come off over the year and until now.
The chart below shows that market implied probabilities of a third hike in 2017 have come off sharply since the beginning of July, precisely at the time when headline Consumer Price Index readings dropped below 2%, and Personal Consumption Expenditures (the Fed's preferred inflation gauge) fell below 1.5%. There currently is a 25% implied probability of a hike before year end, the lowest levels registered this year.
Importantly, the core version of the Personal Consumption Expenditures price index, which tracks items other than food and energy, has slowed down by nearly 0.5% compared with a year ago. Overall inflation remains at 1.4% year-on-year, well below the FOMC's target.
Taking into account August's poor job report, the current trend in inflation in the US, and little to no expectations of the Trump Administration to finally implement any inflationary measure before the end of the year, it is hard to expect further action from the Federal Reserve during the same period.
One of the keys lies on how the FOMC officials incorporate the aforementioned jobs report into their economic outlook.
The FOMC will be hesitant to hike rates again in 2017
FOMC's Lael Brainard, currently one of the most influential members of the committee due to her studies on inflation and neutral rates, spoke earlier this week before The Economic Club of New York.
To quickly recap, Brainard said that prospects of an aggressive fiscal policy at the beginning of 2017 did increase hers and other observers' expectations of a boost in domestic demand. However, on her own words, such prospects have been downgraded over the course of the year, and as a result the Governor has revised her own economic outlook accordingly.
Brainard talks down the transitory effects that are dragging down inflation, arguing that other factors could have boosted inflation last year (i.e. prescription drug prices). But the key lies on what could be the critical factors dragging down inflation despite an unemployment rate below 5%: the underlying trend of inflation, or economic participants' inflation expectations.
Ultimately, Brainard argues that in order to boost the underlying trend of inflation, it would be needed further caution before hiking again, especially now that all of the FOMC participants support the normalization of the Fed's balance sheet.
Neel Kashkari, voting member of the FOMC, also indicated this week that premature rate hikes could have been counterproductive for the economy, suggesting that the poor figures on the latest labor market report could have been influenced by the interest rate hikes implemented over the last two years.
Lastly, after the resignation of the vice chair of the U.S. Federal Reserve, Stanley Fischer, the FOMC loses one of its most prominent hawks, leaving the "dove camp" severely low on numbers.
In conclusion I expect EURUSD (FXE) to close the year above 1.20 and the Dollar Index (UUP) to maintain the downward trend. The ECB will delay any announcement of changes on its strategy of monetary policy until October or December, but after the German elections, the ECB will have a solid case to hike rates, should Merkel win (I discuss the reasons here)
The scenario of no more hikes in the US this year is supportive of US equity markets (SPY, QQQ), although a number of challenges lie ahead before, i.e. debt ceiling deadline, North Korea, etc. If all these issues are solved smoothly, US equities would be supported by monetary policy action, or lack of it.
Disclosure: I am/we are long FXE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.