Salman Ahmed, Chief Investment Strategist

Federal Reserve readies for December market hike

As widely expected the Federal Reserve kept monetary policy unchanged at July's meeting. The accompanying statement was little changed compared to the one released in June, however two elements have caught our and the markets attention.

The FOMC acknowledged that 'inflation and the measure excluding food and energy prices have declined and are running below 2 percent'. Moreover, the FOMC expects inflation to remain 'somewhat below' its policy objective at 2%, but adding that the risk to this outlook is balanced. Second, the FOMC said that it 'expects to begin implementing its balance sheet normalisation program relatively soon', changing from 'by the end of the year' at the June meeting. We believe this means the Fed is considering making such an announcement, either at the September or October meeting.

The market has interpreted the FOMC statement as dovish, as evidenced by the depreciation in USD and the decline in US yields following its release. The market seems to have taken the view that low inflation means that, while the Fed is likely to announce the start of the normalisation in coming months, the central bank will have difficulties increasing its policy rate further. Moreover, some in the market also view the flexible wording for expecting timing for the announcement of the balance sheet normalization, as a sign that the Fed remains uncertain about its timing and wants to keep its options open.

We disagree with the market interpretation of the Fed decision. As we have argued previously, it seems that the Fed may be somewhat changing its reaction function. The Fed seems to be tilting its focus toward financial stability; more precisely overvaluation of certain assets and the impact it could have on the economy in the future. We believe that with the US economy operating very close to potential, the Fed is ready to continue monetary tightening despite the weakness in inflation; weakness that is in part the result of base effects. We expect the Fed to announce the start of the normalisation process of its balance sheet at the September meeting and would not be surprised if the central bank hikes interest rates further at the December meeting, if inflation does not exhibit further unexpected deceleration.

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