Oct 3, 2017

Economic Outlook October 2017

Federal Reserve Monetary Policy
The Federal Reserve committed to starting its balance sheet reduction this month. Shrinking the balance sheet is another way of reducing liquidity in the economy, similar to increasing the Fed fund rate, which currently stands at 1.25 percent. A reduction of $6 to $10 billion per month is not much compared to the Fed’s $4.5 trillion balance sheet, but the market does need to absorb this supply of bonds. It appears there is plenty of demand. Even so, this step by the Fed could push longer-term interest rates higher at some point. The Federal Reserve next meets November 1.

The year-over-year inflation rate for August, the latest data available, was 1.9 percent. Inflation remains below the Fed’s target 2 percent inflation rate, but there is a chance it will hit 2 or maybe even 2.1 percent this month. The Fed uses personal consumption expenditures (the measure of consumer spending on goods and services) to measure its inflation target, and that figure is currently 1.3 percent.

Economic Activity
Consumer sentiment came under slight pressure in the wake of the storms in Texas, Florida and Puerto Rico. We expect this to be temporary, since cleanup and rebuilding from these storms should provide more job opportunities for quite some time. The extent to which these storms dented consumption in the near term should be offset in multiples longer term, adding to economic growth in the future. It is unfortunate this news does not come from better circumstances.

Other topics on consumers’ minds are tensions with North Korea, the partisan divide in Congress, and a tighter housing market in which the supply of homes has declined, making it harder to buy a home.

Tax reform is now the latest news topic. Perhaps it will become simpler to prepare tax returns and realign the U.S. competitive position in global markets, but it is not yet clear if these possibilities will have much impact on economic growth in the near term.

Fixed Income
In late August, the 10-year U.S. Treasury bond’s interest rate was 2.1 percent. That level is now 2.33 percent. In the world of fixed-income markets, this is a big move. Rising interest rates erode the market value of fixed-income securities.

Many investors may be wondering if this increase is finally the beginning of the previously forecast rising interest-rate environment. After all, the Fed has increased the short-term Fed fund rate four times since December 2015, but longer-term Treasury bond yields did not follow. It is too early to tell how the Fed’s balance sheet reduction will affect the market. All else being equal, its effect should be to push longer-term interest rates a bit higher. However, the effect may be muted in the near term by the elevated demand for bonds that exists in the market.

Stock Market
Prior to the Federal Reserve’s experiment with quantitative easing (by buying bonds in the market and carrying them on the Fed’s balance sheet), the equity market moved up and down based on the fundamentals of the market. The correlation between the stock market and the Fed’s balance sheet was nearly zero. Since quantitative easing began, the correlation has moved to nearly one, which means the Fed has been driving the stock market. We point this out because the Fed has indicated it will begin reducing its balance sheet. If the correlation remains this strong, this step could put downward pressure on the stock market.

financial chart
Source: Bloomberg

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