Jerome Powell’s peaceful rhetoric can weaken the effect of the Fed’s improved projections

The USA is committing a suicide, expanding the budget deficit and increasing the interest rate at the same time. But, I’m afraid, the Fed has no choice. In May, the gap between the budget income and spending expanded by 66%, up to $146.8 bn, during eight months of the current financial year- by 23%, up to $532.2. Congressional Budget Office expects the deficit to cover $804 bn in 2018/2019, after $665 bn in 2017/2018. The higher is the federal funds rate, the more will be the borrowing costs. Anyway, they should have thought about this when they were adopting the tax reform.

The Fed’s dual mandate makes it not only continue monetary normalization, but think over speeding it up as well. When unemployment is down at its eighteen-month low, and consumer prices growth is up at 2.8%, and the core inflation – at 2.2% Y-o-Y; anybody would suspect, the economy is going to get overheated. Yes, the central bank would rather follow PCE, which is lagging behind CPI and core CPI by 0.4 bps; however, for now, it has been at 2% target level for two months already.

Dynamics of the USA inflation

Source: Wall Street Journal 

The FOMC doves are likely to refer to 11.7% YoY growth of fuel prices, including the increased gasoline cost at $2.9 per gallon in May, compared to $2.48 in December. I, personally, think it is more important that the Fed is trying to prove that it controls the situation. During the past few years, the central bank was persuading the markets that it could manage the inflation rate below the target; now, it is about the indicator to be above the target. The FOMC improved projections, first of all, for its interest rate, can well encourage EUR/USD bears to go ahead; however, Jerome Powell's peaceful rhetoric will bring sellers back down to earth. Besides, investors must be extremely careful, as Mario Draghi is following the Fed’s Chairman in a few hours.

Peter Praet’s hints at the discussion of QE end increased the odds of the ECB hiking the interest rate. The derivative market expects it to do in September, 2019. This factor, together with easing political risks and gradual Eurozone economy’s restoring, suggests optimistic forecasts fro euro. Credit Agricole expects it to cost $1.26 in late 2018, Societe Generale claims EUR/USD to reach 1.3 over the next 6-12 months.

Dynamics of probability of ECB rate increase

Source: Bloomberg
 So, investors are now focused on monetary policy. They forgot about trade wars. Anyway, are they worth remembering if the suggested tariffs will come out a hundredth of a percent of the US GDP in the next 5 years? It is like a mosquito bite for the US economy, inspired by the huge fiscal stimulus. As long as EUR/USD is below 1.1815, the sentiment remains bearish; nevertheless, the quotes will hardly go down lower then 1.15-1.16

 
 


 


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