After The June Hikes, What Next?

Any doubts during the interim between the previous two FOMC meetings about what the Fed might do were resolved by what appears to have been a coordinated series of hawkish statements by various Board members in the remaining weeks before the late-June meeting, making the result a foregone conclusion, sending stock markets into a tailspin and buoying the dollar, staying afloat at the lower end of its current 1.25-1.29 range against the euro, even as long-term rates surged ahead to the 5.20 level and beyond.

Buy The Rumor, Sell The Fact

In the event, the Fed once again raised policy rates one one-quarter of a point, and the markets reacted with a stock market rally, firmer bond prices, sending the long-term rate back down to around 5.12, while the dollar shot back down to the upper part of its current range against the euro. I interpret this as the stock market with a dovish interpretation of the FOMC statement explaining the policy action, profit-taking on the bond market and, perhaps most significantly, caution on the part of currency market participants concerned about the twin deficits in case of a pause at the next meeting or meetings.

In the most recent days, however, stock markets are back in the red, at least in Europe with the US slowed by a holiday-shortened week, the long-term rate has inched back up to around 5.15%, while the dollar is in the middle part of its range against the euro.

For some months now, the Fed has clearly indicated that policy going forward will be data dependent. Now, in this blog I have already addressed the issue of the quality of the inflation data, and GDP data for the second quarter has not been released yet, though the Fed certainly has a more up-to-date picture than most other market participants. In the end, the stock market enthusiasm may prove to be pre-mature, or perhaps the move up has been more profit-taking on short positions rather than expectations of faster corporate earnings growth going forward based on fundamentals.

In the United States, some are seriously concerned about the possibility of higher inflation combined with not only a slowdown, but even a recession, perhaps prompted by excessive tightening by the Fed, but more so because of the weight of excess debt. Others argue, on the other hand, that despite the high debt levels (both private and government, reflected in the gaping trade deficit), the situation is under control by virtue of the high productivity of the US economy and so the expectation that the debt can be overcome in the medium/long-term through growth, with some slowdown now, followed by renewed acceleration later.

So the Fed must do a tight-rope walk at high altitude, seeking a balance between maintaining the value of the dollar in the face of high levels of debt supported to a large extent by foreign purchases of treasury securities, on the one hand, and economic growth on the other, equally in the face of high levels of debt supported, however, by what probably still is the most productive, or at least the most efficient, economic system in the world in terms of the production and distribution of goods and services.

Depending on the second quarter GDP data, then, and indications that the Fed may have at mid-third quarter, the monetary authority may indeed risk a pause at the FOMC meeting scheduled for August 8 when many people are on vacation. But it may also prove to be too risky, in the face of real inflation, especially at a time when currency markets are relatively thin.

So, once again, unless the second quarter GDP data clearly show a significant slowdown in growth (say below 3%), the balance of risks, in my view, still suggests further 25 basis-point rises in policy rates by the Fed.