The Fed’s Policy Conundrum

The Federal Open Market Committee (FOMC) announced last Wednesday that it would keep interest rates unchanged, a decision that markets largely expected. However, the FOMC upgraded its view of the economy to characterize it as growing at a “strong” rate for the first time since 2006.

The Federal Reserve’s (Fed’s) decision highlighted one of the biggest current debates among investors: the future path of U.S. monetary policy. In a vacuum, the macroeconomic backdrop supports a gradual approach to raising rates, but domestic and global crosswinds have muddled the case for this approach.

“The current approach to raising interest rates isn’t aggressive enough to derail the domestic or global economy, all things considered,” said LPL Research Chief Investment Strategist John Lynch. “We believe a gradual approach is unlikely to result in a policy mistake.”

Market sentiment agrees with the gradual approach to tightening. As shown in our LPL Chart of the Day, Fed funds futures are pricing in about a 60% chance of two additional rate hikes by the end of 2018.

However, the Fed is contending with the following crosswinds:

Tepid inflation: As the economy strengthens, inflation has emerged at a slow and inconsistent rate. While core personal consumption expenditures (PCE)—the Fed’s preferred measure of inflation—have met or exceeded the Fed’s 2% target for four straight months, wage growth has remained subdued. The Fed is also contending with the flattest yield curve—in which the spread between longer-term and shorter-term interest rates falls—since before the financial crisis, reflecting in part fixed-income investors’ hesitations around longer-term inflation expectations.

U.S. dollar strength: The U.S. dollar has recently been hovering near 12-month highs relative to a global basket of currencies. Any further gains could destabilize other currencies and eventually upend international economies reliant on U.S. imports by fueling rapid price growth in those countries.

Trade tensions: The intensifying global trade rift also presents a growing headwind for the Fed. Over time, tariffs are likely to drive prices up, and there is already anecdotal evidence that uncertainty around tariffs may be delaying additional business spending as companies await greater clarity.

Balance sheet unwind: The Fed must also manage the unwinding of its balance sheet, a program scheduled to peak in October, with its gradual approach to increasing rates.

Check out this week’s Weekly Economic Commentary and Bond Market Perspectives publications for more insights on these crosswinds, the health of the economy, and the implications of the Fed’s next moves on fixed income.


*Please note: The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of predecessor index, the S&P 90.

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