“It’s a good thing,reflective of strong and healthy spending,productivity improvements and most likely not creating an inflationary challenge,” she said.
For the Fed,of course,that is the multitrillion-dollar question. Can you have growth this strong,with unemployment so low,with real wages and consumer confidence rising and the US sharemarket at record levels without risking a rekindling of inflation?
The alternative view is that,if inflation is now at or below the Fed’s target and its view that the “neutral rate” – the interest rate that enables the economy to operate at its full capacity while maintaining a stable inflation rate – is about 2.5 per cent,then a federal funds rate of 5.25 to 5.5 per cent,or a real interest rate more than 3 percentage points above the neutral rate,risks unnecessary damage to the economy.
The lags between monetary policy actions and their effects are quite large,so the risk of leaving policy too restrictive for too long and perhaps undermining what now appears to be a soft landing for the economy is quite real.
When the Fed’s Open Market Committee (the FOMC makes the monetary policy decisions) meets on Tuesday and Wednesday,there is no expectation within the markets that a rate cut will be announced after completion of the meeting.
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After chairman Jerome Powell and a number of influential Fed members canvassed the prospect of rate cuts this year – the famous FOMC“dot plot” of its members’ forecasts showed the median projection was for three 25 basis point cuts – the markets embraced the shift in the Fed’s stance from hawkish to dovish with enthusiasm.
As many as six rate reductions are priced into the markets,with the odds on the first occurring at the Fed’s March meeting roughly 50:50.
The Fed’s post-meeting statement,and Powell’s press conference remarks,will be pored over by investors and analysts seeking to get a sense of the timing and magnitude of the expected rate reductions this year.
Whether it moves in March,and whether there are three rate cuts or five or six,will obviously depend on the Fed’s perception of the balance of the risks of either moving too quickly or too slowly in response to the falling inflation rate.
Given the extent to which aggressive rate cuts are priced into markets,particularly the sharemarket and currency markets,even a hint of the Fed’s preferred course of action could have significant and immediate implications for the markets and the prices of the big tech stocks that have driven the US sharemarket to record levels in particular.
Many of those stocks – Microsoft,Alphabet (Google’s parent),Meta (Facebook’s parent),Amazon and Apple – will report their earnings this week,so the coincidence of the Fed’s meeting makes this a major moment for the near-term direction of the markets.
The performance of the US economy – its ability to power through rising real rates,an unhelpful global economic environment,unsettling geopolitical conflicts and tensions and a dysfunctional Congress – owes a lot to the vast amount of fiscal stimulus that has poured into the economy in recent years.
Trillions of dollars of stimulus and financial support for households were disbursed in the response to the pandemic,with Joe Biden also wiping out billions of dollars of student debts and,via his infrastructure spending,incentives for domestic semiconductor manufacturing and clean climate incentives,pouring more trillions into the system.
The lags between monetary policy actions and their effects are quite large,so the risk of leaving policy too restrictive for too long and perhaps undermining what now appears to be a soft landing for the economy is quite real.
That’s come at a long-term cost in the form of a big increase in America’s national debt,debt that was already surging even before Biden took office. During Donald Trump’s term the federal government’s debt rose almost $US8 trillion ($12.2 trillion),to just under $US28 trillion. It’s now just over $US34 trillion.
If the US economy continues to grow at its current rate,and interest rates do fall significantly,of course,the cost of servicing that debt will become less daunting. The Fed’s ability to finesse a soft landing is critical for American households and businesses,but also for the stability of the government’s financing.
It also has political implications in an election year. Biden’s poor approval rating owed much to consumers’ discontent about the rising cost of living during the lengthy period of elevated inflation and negativity about the state of the economy.
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A falling inflation rate,evidence of strong economic growth and the expectation of rate cuts is turning that around – and making the Fed’s decision-making potentially a big political issue.
There’s little doubt that a succession of rate cuts this year in the lead-up to the November election will be characterised as Fed support for Biden by the Trump camp or that,if Trump were to win the presidential election,that he would again attack the Fed and try (as he did during his last term) to remake its board into one that does his bidding.
That combination of the potential economic and political effects of the Fed’s decisions this year will add to the weight of the decision-making,although the Powell-led Fed will presumably be – almost certainly will be – far more focused on the economics than the politics.
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