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Federal Reserve Sets the Stage

RFP
The Federal Open Market Committee (FOMC) decided to hold rates steady at the current 1.5% to 2% target range, while the most important change to come out of this meeting was that the word “strong” used to describe the economy. This represents an upgrade from the word “solid” in June when the Fed raised rates. More than any other word, “strong” sets the stage for another rate hike in September.

Another factor weighing on the decision in September is the concern that tariffs will increase the pace of inflation. Two new manufacturing surveys signaled concern about the effect tariffs will have on prices, with more pressure expected to show up in the third quarter. This was echoed in recent announcements of price hikes for everything from vehicles, boats and construction machinery to smartphones.

The minutes from FOMC meetings are becoming more and more important as participants hash out risks of everything from overheating to an all-out trade war. They are getting reports that a further escalation in tariffs could crimp investment down the road. However, it is important to remember that the Fed can only react to economic data when it is actually reported. The Fed is quite limited in what it can do to preempt changes in growth. For example, the Fed cannot stop raising rates in anticipation of a slowdown from tariffs until those effects actually show up in the data. Moreover, tariffs act as a tax on consumers and producers; that shows up in inflation (which the Fed is mandated to combat) before it dampens growth.

Our forecast holds for two more rate hikes in 2018. Factors that could change the forecast include a large financial market correction, or a flurry of junk bond defaults, tied to an all-out trade war. The probability fluctuates by the day. The rise in nonfinancial debt has been substantial as retail buyers reach for the higher yields in the junk bond market.

Another factor to watch is the composition of the voting members of the FOMC, which shifted in August. Kansas City Fed President Esther George replaced former San Francisco Fed President John Williams on the FOMC. Williams has moved to the New York Fed to fill the Vice Chair position on the FOMC. George is a known hawk, who will exert her influence to raise rates in September.

Bottom Line
Current strength in the economy, combined with upward pressure on prices from tariffs, virtually ensures a September rate hike. A December rate hike is also still a solid bet.

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