Is the Fed taking note of market volatility? - Butler Financial, LTD
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Is the Fed taking note of market volatility?

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The Federal Reserve (Fed) only controls one rate of interest, and it is a very short-term rate called the federal funds rate, the rate that banks charge each other for overnight, intra-bank loans. The rest of the rates, i.e., longer-term rates, are determined by the markets. Thus, when the Fed increases the federal funds rate, it does that by selling bonds into the market and thus ‘drying’ the market of liquidity. This reverberates in the market for loanable funds, pushing longer-term interest rates higher across all of the maturities.

It is a very inefficient way of doing things, but it is the only way it has to influence market interest rates, and more times than not, the market reaction to a higher federal funds rate does not translate into precisely what Fed officials are expecting in terms of longer-term interest rates. So, when that is not enough, they use another, less ‘scientific’ instrument, something they call ‘guidance’. Sometimes this ‘guidance’ is not effective, and markets disregard it. However, since the September Federal Open Market Committee (FOMC) meeting, something ticked with markets and the ‘guidance’ Fed officials had been giving for many, many months, finally caught the market’s attention. That is, after the FOMC meeting in September, markets finally took their ‘guidance’ to heart: “higher interest rates for longer.”

Since then, the yield on the 10-year Treasury has skyrocketed and hit a high of 4.85% today. Now, of course, many have come out predicting that the yield on the 10-year Treasury will hit 5%, which would have been a risky call several months ago, but not today.

This surge in long-term yields is going to put further upward pressure on mortgage rates and is probably going to weaken the housing market again, with the caveat that the still very low inventory of homes could keep new home sales going stronger than what otherwise would have been the case given such high mortgage rates.

Thus, if monetary policy decisions were difficult up until now, they have become even more difficult today. That is, before September of 2023, Fed officials had been increasing interest rates and giving ‘guidance’ to the markets so longer-term interest rate would increase to the Fed’s desired level, a level that was enough to constrain economic growth. So far, higher interest rates have done little to slow down economic activity, but it is difficult to know if the reason for this is that interest rates are not high enough or if the normal lag with which monetary policy works is such that the Fed has to wait until those increases in interest rates affect economic activity.

Furthermore, working in favor of the Fed is the fact that even as the economy has remained strong, inflation continues to weaken without the need for the economy to slow down or for the rate of unemployment to go higher.

Today, we think the Fed’s ‘guidance’ has finally made a dent on markets and thus policy decisions will have to be recalibrated. In short, the Fed has to choose between two paths: increase rates further to guide and keep markets from disregarding its guidance or consider its job to be done and therefore hold rates where they are. The answer is not an easy one as the first option would likely prevent interest rates from decreasing but weaken the economy further, while the second one might be less strain on the economy but turn out to be counterproductive and ultimately risk pushing rates lower. We suspect the Fed will probably wait until the end of the year to have more certainty on what its next steps are going to be.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of 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 US Bureau of Labor Statistics. Currencies investing is 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.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren’t part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy’s movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies. The Index goes up when the U.S. dollar gains “strength” when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers’ Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023

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