While our model needs to be adjusted, as noted below, we remain confident in these results.
The first forecast adjustment element are the previous hikes. Recall that in March, 2018, our model predicted a rate increase with a 92.3% probability. The rate increase following the June 12 – 13 FOMC meeting decreases the probability of subsequent rate increases, if only slightly (90.53% vs 92.30%). One precedent for the Fed raising rates in this manner came in 1994, during the Clinton Administration, when the Fed raised rates from February to May at a 25 basis point pace. Interest rates increased from 3.25% to 4.25% in 4 months (FED, 2018).
Each successive rate increase adds less to policy impact. Given that the Fed has raised interest rates two times so far in 2018, the fact that the probability has fallen is consistent with our thinking.
The second forecast adjustment concerns inflation. Both Core PCE and CPI continued increasing in June and are now thought to represent a trend. Core PCE references living expenditures excluding food and energy. Yes, the impact on inflation of a trade war must be considered, also. The current Administration has initiated several tariff increases against China, Canada, Europe, NAFTA partners and others. A trade war makes it harder for the Federal Reserve to increase rates, since tariffs increase expectations concerning inflation by increasing prices for the purchased goods that are subject to a tariff. The Fed will want to be cautious about stoking runaway inflationary expectations. Indeed, the impact of the previous interest rate hikes and the looming trade war caused the Dow Jones Industrial Index to fall from 25320.73 on June 12th to 24174.82 on July 3rd. Uncertainty concerning trade will definitely have unpleasant impacts on industrial production, even with minor buffer policies, like allowing ZTE is resuming activities temporarily (Jenny Leonard, 2018).
In summary, the Fed will consider the impact on inflation of a trade war and might continue increasing interest rates but at a slower pace if the situation worsens.
Consumers are the third forecast adjustment factor. Our model uses two major indicators of consumer expectations: Consumer Sentiment, which indicates the confidence consumers have in the economy, and inflation expectations -consumer expectations concerning changes in the prices of goods. The Fed may wish to stop increasing rates in order to give consumer confidence time to adjust.
Given these factors, our adjusted probability of a Fed rate hike is lower than the unadjusted 90.53% probability. The next Fed Interest Rate Decision will be made public on Aug 01, 2018 02:00PM ET.
Research by Ryan Brand, Rongbin Ye, Impact Investing Analysts. EDITED BY WILLIAM MICHAEL CUNNINGHAM
References
Bloomberg Database. (2018). Dow Jones Industrial index & Yield Curve & Interest rate expectation. Retrieved from Bloomberg Terminal.
Federal Reserve Database. (2018). FED Economic Data. Retrieved on July 3rd from: https://fred.stlouisfed.org