June 21, 2018
Market Commentary
Fed Raises Rate As Trade Risks Escalate

This was a busy week for soccer fans and investors alike. The former got treated to a kickoff of a month-long FIFA World Cup extravaganza in Russia, while the latter had a full docket of policy decisions from the Fed and the European Central Bank, as well as readings on inflation and retail sales and to close off the week an announcement of 25% tariffs on $50 billion of goods imported from China.

Tuesday’s inflation report got the ball rolling ahead of the FOMC rate announcement. As widely expected, inflation continued to gain traction in May. The headline and core consumer price indexes rose by 0.2pp (m/m) apiece to 2.8% and 2.2% (year over year), respectively. A strong economy, wage pressures and (now) tariffs will continue to push inflation measures higher in the coming months, particularly as businesses become more comfortable with passing higher costs to consumers (see Chart 1).

The Fed’s June rate hike looked like a done deal even before the inflation report, and indeed the FOMC raised the federal funds rate target by 25 basis points to a range between 1.75% and 2.0%. Details of the statement and the accompanying economic projections were insightful. Notably, the statement removed its forward guidance that the “federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” With committee member projections showing the federal funds rate rising above its anticipated “longer run” rate by 2019, this made sense. The Fed’s increased confidence in its rate hiking path was also illustrated in an edging up of the median expectation for the fed funds rate to 2.4% (from 2.1%) this year, implying two more rate hikes this year (one more than previously). During the press conference, Chairmen Powell also said that starting next year he will be holding a press conference following every FOMC meeting, a move likely aimed at freeing up Fed’s hands somewhat with respect to future rate changes.

The Fed’s view that economic growth is revving up was corroborated Thursday’s retail sales report. Spurred by tax cuts, job gains and rising incomes, American consumers have been on a tear for the last three months, and in May retail sales surged by 0.8% – double the expectations and the biggest jump in half a year. Helped along by a pickup in consumer spending, GDP growth is currently expected to surpass 4% (annualized) in the second quarter, and average 3% for the year as whole – the best result since 2005.

While the U.S. economy may be sizzling, there are risks on the horizon. As with tariffs on steel and aluminum, the recent tariff announcement on Chinese goods sparked a retaliatory action by China. Taken alone these tariffs are likely to present a modest drag on U.S. growth and modest lift to inflation (please see our recent report on U.S.-China tariffs). However, while direct impacts are modest, the hit to business confidence and supply chain disruptions could result in a more deleterious effect on growth, So far, financial markets have taken these skirmishes in stride, but a further escalation or full out trade war could bring this assumption into question.

Ksenia Bushmeneva, Economist | 416-308-7392

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2018-06-21T17:26:34+00:00