Policy Watch Regime Change*
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By Carlos B. Cavalcanti @ ResearchGate March 2018 Since the Federal Open Market Committee (FOMC) met last, on January 31-February 1, there were two important developments: the stock market plunged and then recovered partially but at a much higher market volatility level, (Figures 1 and 2) and the U.S. Congress approved a larger-then-expected government funding bill for 2018 and 2019.2 How will the Fed respond to these developments? An answer depends on whether the FOMC understands that the approved budget package will mainly boost aggregate demand or lead to an expansion in economic capacity by encouraging investment.
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* Comments are welcome. Email:
[email protected]. DOI: 10.13140/RG.2.2.35667.48160 2 Also, in late-2017, a tax overhaul totaling U.S.$ 1.5 trillion over the next ten years reduced corporate income taxes and provided a one-time tax break aimed at encouraging corporations to repatriate overseas profits.
Figure 2: Chicago Board of Exchange Volatility Index, 2018 39.00 34.00 29.00 24.00 19.00 14.00
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An upbeat assessment made by the new Fed Chairman (Jerome Powell) to the House Financial Services Committee of the U.S. Congress on February 28th endorsed the first scenario by suggesting that the Fed would stay on track with the strategy of gradually increasing the benchmark interest rates. The markets immediate reaction from his speech was an outflow of investment from the stock and property market, since the speech was viewed as supporting the need for a preemptive monetary tightening. It argued that the labor market was strong, having added an average of 180,000 jobs a month over the last 6 months, and inflation showed signs of accelerating, printing 2.1% in January, slightly above the Fed’s 2.o% target (Figure 3). Expectations of increasing inflation are reflected in the rising gap between yields on 10-year nominal and 10-year inflation-protected Treasury securities (Figure 4).
Figure 3: Consumer and Producer Price Indexes, 2017-2018 (Annual % Change) 3.50 3.00
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Figure 4: Difference in Yilelds Between 10-year Nominal and Inflation Protected Treasury Securities, 2017-2018 (%) 2.20 2.10 2.00 1.90 1.80 1.70 1.60
Market indicators also appear to endorse the first scenario. At first, market opened a gap in the yields between 10-year and 2-year Treasury securities (Figure 5) suggesting that investors were shunning longer term assets. This rising gap was swiftly reversed, however, as investors became more cautious and yields 2-year bonds also rose.3 Then on March 1 the U.S. administration suggested it would raise tariffs on the imports of steel (25%) and aluminum (10%) further widened this gap, as investors became 3
These rising yields on safe-securities diminish the allure of high-dividend stocks.
concerned with the risk of a trade war,4 and sought protection in holding short term, safe assets. All these trends point to rising uncertainty and, as a result, an increase in the liquidity premium. Figure 5: Difference in Yilelds Between 10-year Nominal and Inflation Protected Treasury Securities, 2017-2018 (%) 2.20
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Conclusion. Will the Fed lift its benchmark federal-funds rate four times in 2018, rather than the three moves penciled in by officials in December 2017? Although it is early to tell if interest rates will be raised three times or more this year, what is clear is that the Fed has entered into a new regime. The one thing that is certain is that at the next meeting on March 20 and 21 the benchmark interest rates will be raised again by 0.25%.
The Trump administration announcement marks the largest step to date to carry out the administration’s 'America First' trade policy aimed at upending decades of US leadership fostering globalization. 4
