What a difference can a few days make! When on February 2 it was announced that wages in the U.S. rose by 2.9 percent (and that, after a revision, wages in December rose a bit more than previously estimated), stock market prices began to swing violently. Stock market indexes lost hundreds of points per minute and long-term interest rates rose to heights last seen in 2014. At times, investors even began to believe that the official rate in the US will be raised four times and not three times, as the central bank had more or less promised.
All these things played out days after a meeting of the Fed’s interest-rate-setting committee (FOMC) at the end of January. This week, the minutes of this meeting were released to the public. How did Fed members expect the US economy to develop in 2018 and how can we view their concerns in the light of the recent volatility on markets and the recent economic developments?The decision makers of the Federal Reserve are unshakably optimistic about the prospects of economic growth. Trump’s tax cuts, the high and steady growth of the global economy and the positive sentiment on financial markets (read: low interest rates, increasingly high stock market prices), were mentioned as important reasons. Some FOMC members even adjusted their own economic growth expectations upward for the current year. One of the FOMC’s members recently said in an interview that the “U.S. economy appears healthy and to be in its best shape since the crisis.” According to him, the economy is by some measures performing even better than the period before the last crisis.
After the release of the Fed minutes, long-term interest rates climbed slightly and stock market prices came under severe downward pressure. The dollar strengthened somewhat from what it lost over the past few weeks. The reason was one single word in the Fed’s minutes, that is, the word “further.” Whereas before January the Fed talked about the necessity of “gradual interest rate hikes” in 2018, the minutes now mentioned “further gradual rate hikes.”
Yet I posit that we should not interpret “further” as “more rate hikes than promised,” but rather as “three rate hikes as planned after the increase in December last year.”
Whereas the Fed was quite optimistic about the prospects of economic growth (although we should mention the fact that some members see risks that could throw off current forecasts increasing), it is quite the contrary with regard to inflation.While some of the FOMC’s members were concerned that economic growth could increase and push up inflation, a large group feared that inflation could continue to be low for a considerable longer period of time, significantly below the Fed’s target of 2 to 2.5 percent. In other words: the Fed still finds itself clouded in great uncertainty about how to face this new economic phase (first after a recession and decreasing inflation, after which recession and deflation dangers were luring in the shadow, only to be followed by an economic recovery and a much too low rate of inflation) of persistent growth and higher inflation than earlier but still too low. Are such troubles temporary or is growth fundamentally at risk? Are the slightly increasing long-term interest rates for instance a sign that, according to the opinion of the bond market, the Fed is falling behind the curve? In other words, is the Fed raising rates too slowly given the recent economic developments? Time will tell. What I do want to mention, however, is that even in light of the above it remains very important who will fill the four vacancies in the FOMC in the coming months. Given the large number of vacancies, new appointees could tip the scale toward one or another vision on future monetary policy.
The common denominator for a large majority of FOMC members is that they view inflation in the U.S. strengthening in the mid-term toward their desired inflation target, as economic growth will remain above trend and the labor market will remain strong. And that is, in my view, very important for us.
This proves that just one piece of slightly disappointing data on economic growth and/or inflation (or any other important indicators of such variables!), could lead to a moderation of rate hike expectations for this year, with dire consequences for financial markets. Given the fact that monthly inflation figures are infamously volatile and that economic growth forecasts can be revised and adjusted significantly after their initial estimates, this is something that could easily happen.
On the other side, somewhat stronger macro-economic data could also result in a strengthening of the idea that the Fed will raise rates four more times this year, which would produce a stronger dollar, higher interest rates and declining stock market prices.
It would not surprise me if every time that important macroeconomic data is released, markets will increasingly discount the new data to anticipate Fed policy. In the short term, we could think of inflation figures and data on domestic consumption (to be released on March, 1), the monthly labor market report with new jobs, unemployment and wages (on March, 2), or the non-manufacturing PMI Index (on March, 5).
All the above means that we can easily expect higher volatility in the near future, more than we got accustomed to over the past few years (the turbulence of the past weeks can become more common, rather than some temporary phenomenon). This implies that sudden declines in stock prices as we have seen earlier this month are very much possible, just as much as greater jumps in the case of positive data. I believe “volatility” is much more likely to become the most-heard phrase on financial markets in 2018 than “inflation.” If that will have a positive effect on precious metals prices remains to be seen. If 2018 turns out to be the year of interest rate hikes, even if they are limited to three hikes, and growth remains high while inflation gradually increases, then I would not be surprised to see precious metals prices at lower levels around Christmas than current prices. The fact that gold prices have failed to pass the $1,400/oz limit for various years, backtracking every time they even got near, is not a very promising sign. And when I look beyond 2018, then I see little reason to revise my earlier mentioned expectation of further increases in precious metals prices.