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Financial Expertise

US Federal Reserve: in a policy dilemma

Financial Expertise

US Federal Reserve: in a policy dilemma

Hurricane Harvey and persistently low US inflation levels are increasingly pushing the Federal Reserve (Fed) into a policy dilemma, a challenging balance-sheet reduction and a December rate hike. Overall, we believe that the Fed is likely to wait with its planned policy measures until the federal budget and debt ceiling issues are solved and inflation levels offer more clarity of direction.

The latest developments in the USA currently suggest an increasing policy dilemma for the Fed. Given the latest evidence, hurricane Harvey’s financial fallout in the USA is very likely to delay the Fed’s planned balance-sheet reduction. In fact, hurricane Harvey inflicted flood damages with wealth losses beyond USD 100 billion, of which only the smaller part is insured. The Trump administration aims to include in its new budget the immediate funding of its promised federal relief to the harmed parties, which has a deadline of 30 September. However, this will also affect the definition of the debt ceiling, which should be passed by Congress by 15 October and which Trump’s government intends to increase further.


Short-term bond market anxious about Fed decision
These latest developments are of significant importance for the short-term bond outlook. The bond market is currently worrying that the debt ceiling might be raised quite soon, paving the way for an announcement of the Fed about its proposed balance-sheet reduction on 20 September. Such a scenario would be negative for bonds. However, given the past experience with the inefficient Trump administration and its troubled relationship with Congress, we believe that the Fed is likely to wait until these issues are solved: before reducing its Treasury holdings, the Fed will want to avoid by all means a hefty rise in Treasury yields at short notice. So under these circumstances it becomes rather improbable now that we will see any balance-sheet action at the Fed’s 20 September policy meeting.

Low inflation reduces probability of a rate hike
Besides, the persistently low US inflation levels so far are rather prone to demotivate the Fed from undertaking further rate hikes and could therefore possibly postpone an increase of the Fed fund rate in December. In fact, the latest US inflation indicators like personal consumption expenditure (PCE) inflation, the Fed’s favourite inflation gauge, rose only 1.4% year-on-year in July, which is still far below its inflation comfort level near 2%. In addition, wage growth, which is a leading indicator for inflation, has remained stuck at only 2.5% year-on-year during the last five months in a row, instead of heading up to 3% and beyond.
Overall, the Fed has really been thrust into a short-term policy dilemma that could weigh further on the US dollar, which already has been suffering from bad news flows out of Washington lately. The Federal Open Market Committee’s decision on 20 September will therefore gain market attention.

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