The central bank’s try to choose the lesser of two evils may result in recession

There is always a choice. The Fed can speed up monetary normalization, setting back the US growing GDP rate; or, on the contrary, slow down hiking the rate, supporting the destabilizing inflation. The central bank must consider all the risks, choose the right course and avoid the past mistakes. The benchmarks are the unemployment natural rate and neutral interest rate. If the Fed is wrong with the values, it may lose the right course.

Jerome Powell, speaking in Jackson Hole, gave the example of the 1970s and the 1990s. In the both cases, the Fed was hiking the federal funds rate too slowly in the context of strong economy. The first one resulted in the uncontrolled inflation rate (I should note the White House contribution to that), the second one – in the U.S. economic recession. In the late 1990s, the FOMC, headed by Alan Greenspan, preferred waiting for PCE growth before raising the rate. According to the present chairman of the Federal Reserve, it is a wrong way. The monetary policy is implemented with a time lag. If they ignore that the inflation rate isn’t rising much above the target when the unemployment rate is below its natural level, they can face uncontrollable price increases.

I, personally, liked how Jerome Powell responded to Donald Trump. The Fed’s chairman clearly stated the results of slow monetary normalization. And the derivative market has believed his words that there are no signs of the U.S. economy overheating, and  the inflation rate is exceeding its 2% target. 10-year Treasury yield, responsive to the U.S. economy’s outlook, remains stable. 2-year yields, responsive to the monetary policy, on the contrary, increased. As a result, the yield curve made another step towards the red zone. Its inversion, as the experience of the last five decades suggests, is an accurate recession signal.

Dynamics of the U.S. yield curve


Source: Financial Times

Jerome Powell has proved that the Fed is doing the right thing, but the market hasn’t believed that it won’t result in the recession. What can be the mistake of the central bank, trying to keep the U.S. economy’s steady growth? The wrong interpretation of the benchmarks? In June, the FOMC projected that the U.S. unemployment natural level is between 4.1% and 4.7%, the neutral interest rate is in the range of 2.5%-3%. The first indicator is already down (3.9% in July), the bottom border for the second one can be hit in late 2018 already. It will turn out that the Fed will have no reasons to increase the rate three times in 2019. It will be moving slower than it is expected, sending a bearish signal for the U.S. dollar.

I believe that that the close end of the Fed’s normalization cycle, together with the expectations of monetary normalization in the Euro-area, made EURUSD bears take the profits. The euro price is 7.5% down from the February highs, as it hasn’t consolidated below the psychologically important level of 1.15%, the downtrend is less likely to continue. If euro bulls storm the resistance at 1.165 and 1.173, the euro is getting more likely to increase. Otherwise, if they fail, it will be the evidence of Jerome Powell’s victory.

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Price chart of EURUSD in real time mode

Fed Moved a Piece, It’s Dollar Turn Now

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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