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The Fed is Deftly Walking the Razor's Edge

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The board of the U.S. Federal Reserve meets on Tuesday and Wednesday to assess the state of the economy and make a decision about whether to raise short term interest rates. Traders put the chances of a 25 basis point hike in the target fed funds rate at 93.8%, according to the CME’s (CME - Free Report) “FedWatch” tool which is based on traded prices in the Fed Funds futures contract. The chances of a 50 basis point raise have been increasing and now stand at the remaining 6.2% with essentially no expectation of zero Fed action at this meeting.

Fed Chairman Jay Powell has expressed his intentions to continue with a series of small rate hikes throughout the rest of 2018 and into next year to pump the brakes on a U.S. economy that continues to hum along with GDP growth above 3% annually, unemployment under 4% - which many economists consider to be basically “full employment” – and inflation hovering very close to the Fed’s stated target of 2%.

Source: CMEgroup.com

The markets are pricing in a 74% chance of one additional rate hike by December of 2018, which would bring the target rate to a range of 225-250 basis points which is still below historical averages, but much higher than the zero rates we saw during the financial crisis ten years ago.

Source: CMEgroup.com

The Fed’s most recent “dot plot” - which assesses FOMC participants expectations for appropriate monetary policy over the next two years and beyond – shows a likelihood of 3-5 more 25 basis point moves through the year 2020 with rates normalizing of even declining slightly after that.

Source: Federalreserve.gov

In a sense, this is actually the toughest environment for the Fed to consider these moves. When the economy is clearly sluggish, the Fed can be expected to stimulate growth with a series of rate cuts, and when inflation is raging, everyone expects the Fed to tighten significantly.

During his 8-year tenure as Chairman of the Fed between 1979 and 1987, Paul Volcker faced inflation and unemployment numbers in the double digits and wielded rate hikes as a blunt tool - at one point raising the Fed Funds target rate 4% in a single month. In jindsight, these moves are widely credited with reigning in inflation and setting up the remarkable economic expansion of the 1980s and 90s.

Starting with the Greenspan era and continuing through Bernanke and Yellen, the Fed has taken a more restrained approach, raising and lowering the benchmark short-term rate gradually to stimulate growth and reign in inflationary pressures.

Chairman Powell has endeavored to be as transparent as possible, telegraphing his intentions ahead of time and increasing the frequency of post-meeting press conferences to keep business leaders and the investing public aware of the Fed’s plans and reducing the market impact surrounding interest rate moves.

The equity markets have taken the recent series of rate increases in stride, safe in the knowledge that the Fed’s intentions are to temper increases in inflation while still allowing healthy economic expansion. Powell’s role remains challenging however as he oversees an economy that’s extremely healthy by every measure and seeks to strike a balance between allowing unfettered, inflationary growth and “taking the punch bowl away from the party.”

Unless we see that longshot 50 basis point hike this week or a drastic change in the Fed’s statement on future plans, this week’s action is likely to be largely a non-event. Powell and the board of governors have shown the ability to keep economic growth simmering - but without boiling over - and all signs point to more of the same as we continue to enjoy one of the healthiest economies in history.

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