Economic Monitor – Weekly Commentary
by Eugenio Alemán

To increase or not to increase: That is the question

September 15, 2023

Markets are convinced that the Federal Reserve (Fed) is going to pause its interest rate campaign after it finalizes its Federal Open Market Committee (FOMC) meeting on Wednesday, September 20. While markets are trying to guess what the Fed is going to do, they are not the ones that conduct monetary policy. Monetary policy is the realm of the Fed, which is the country’s central bank.

However, we agree that many times, the Fed does what the market is expecting it to do and, today, markets are expecting the Fed to stay put or pause in September. However, unless Fed officials change their minds regarding interest rates when they release the new dot-plot on Wednesday, even if they pause in September, we should expect the Fed to increase interest rates once more before the end of this year.

But before speculating what the Fed is going to do next week and the information contained in the Summary of Economic Projections (SEP) and the ensuing dot plot, let’s backtrack to June’s FOMC decision to pause, which was followed by an even more startling decision to increase rates once again in July. Why were we startled by these decisions? First of all, because we asked this question: Why did you pause if you were going to increase rates again in July? There wasn’t a ton of new information in July to prompt a move. Second, the rate of inflation for June, which Fed officials had access to when they convened for the July FOMC meeting, was very benign, with both the headline Consumer Price Index (CPI) as well as the core CPI printing a 0.2% monthly rate. Furthermore, both the headline CPI and the core CPI were still coming down on a year earlier basis.

However, today, oil and gasoline prices are putting pressure on headline CPI and that measure has increased for two consecutive months on a year earlier basis, from a ‘low’ of 3.0% in June to 3.2% in July, to now 3.7% in August, not very comforting if you ask us, in terms of monetary policy effectiveness. True, core CPI has continued to come down on a year-over-year basis, and that is very good news for the Fed. However, that rate was still elevated, at 4.3% in August, with services prices increasing more than expected during the month.

Furthermore, with oil and gasoline prices increasing and expected to continue to increase during the rest of this year and with inflation still above the Fed’s target, the risks for inflation to start to move higher once again, or at least for the disinflationary process to moderate, due to the still strong pace of economic activity should be unsettling for monetary policymakers. At the same time, the Fed has been very lucky, so far, that inflation expectations have increased but have not been unanchored (see chart on previous page). However, nobody knows how long expectations, but especially long-term inflation expectations are going to remain contained. And they should not risk trying to get an answer on that question.

This is especially true because the Fed, according to many, has been partially to blame, perhaps a bit unfairly, for being asleep at the wheel when this inflationary process was set in motion. It will not risk being blamed again if inflation starts moving up again.

It is true that monetary policy takes a relatively long time to affect the economy, that is, it works with a lag that has normally been estimated to be between six and twelve months, and it could use this argument to remain on the sidelines for now. Furthermore, it could be argued that the lag on the economy’s response to monetary policy may have been delayed further due to the fiscal stimulus being delivered by three government bills: the CHIPS Act, the IRA, and the Infrastructure Bill (See our “Weekly Economics: Thoughts of the Week” for September 1, 2023).

Whatever the arguments Fed officials may use for deciding the path of monetary policy going forward, the market’s bet that it will pause, which was at 97% on September 15, 2023, seems to be a risky simplification given the difficult tasks ahead for the Fed. We know that markets prefer certainty to uncertainty, but policymakers’ decision during the September meeting of the FOMC is not as clear cut as markets anticipate, even if, in the end, they end up being correct.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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