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The Federal Reserve cut interest rates for the third time in its three-month easing cycle that started with a robust half-point reduction in September. The latest quarter-point cut won’t be the last according to predictions made at the December 17-18 policy meeting. The question is, are we closer to the beginning or the end of the rate-cutting cycle. If we are still in the early stage, the next question is what is the ultimate landing spot – i.e., so-called neutral rate that the Fed believes neither juices nor stifles growth in a stable inflation environment? Predictions of that rate are all over the place, which is not surprising as it is a moving target that has changed dramatically over the years.
Reflections on the U.S. elections are ongoing and will likely dominate the media for some time to come. That said, the polls are closed, and all eyes are focused on what the ramifications of the incoming Trump administration will be for the U.S. economy. Most commentators believe that the prospect of higher tariffs, massive deportations and broadly-based lower taxes are inflationary. We caution, however, that bold campaign proposals are usually watered down before they become actual policies. What’s more, it is a mistake to view a president’s agenda in a vacuum. Higher tariffs invite retaliation by trading partners, leading to unintended consequences that could result in higher business costs, lower profits and, eventually, job cutbacks.
It’s been a rough ride in the financial markets over the past month. The S&P 500 has fallen by more than four percent since hitting a nearby peak on December 6, while the Bellwether 10-year Treasury yield has spiked by nearly three-quarters of a percent, hitting a 15-month high of 4.80 this week. Perceptions as much as fundamentals have underscored the bearish turn of events. Until Friday’s stronger than expected jobs report, there were no major surprises on the economic front. As advertised, policy uncertainty linked to the incoming administration is wreaking havoc on investor expectations, stoking the volatility that many anticipated following the election. It’s still unclear how much of the headline-grabbing campaign proposals will see the light of day and how they would ultimately impact the economy. About the only outcome around which a consensus has formed is that the prospect of higher tariffs, lower taxes and increased deportations heightens the risk that inflation will be stickier than otherwise over the foreseeable future.
The modest Santa rally was rudely interrupted on Friday, as prices slumped amid light trading during this holiday-shortened week. Meanwhile, bond yields continued to tilt higher since the Fed announced its latest rate cut on December 18, moving from 4.40 percent to above 4.60 percent at end the week. Again, it’s hard to read much into market sentiment during the holidays, when traders take vacations and a few large transactions can have an outsized impact on prices. What’s more, there was little in the way of market-moving economic data that would warrant a move in either direction. The next influential report will be released on January 10, when the all-important jobs report for December comes out.
The financial markets are still reeling in the aftermath of the hawkish rate cut by the Fed this week. Stock prices plunged the Wednesday of the Fed meeting and continued to drift lower until a fresh set of positive figures stoked a rally on Friday. Meanwhile, bond yields turned sharply higher, continuing the unsettling trend we’ve seen since September when the Fed put through the first of three rate cuts, culminating in this week’s quarter-point reduction. The latest move leaves the target range for the benchmark federal funds rate at 4.25-4.50 percent, bringing the cumulative decline since September to one percentage point. Conversely, bond yields, as represented by the benchmark 10-year Treasury yield, have been the mirror image of the funds rate. As of Friday, the yield stood at just over 4.50 percent, up nearly a full percentage point from 3.62 percent on the day of the Fed’s September rate-setting meeting.
The tail end of the holiday shopping season is rapidly approaching; by all accounts, consumers are in a festive mood, keeping their wallets open and purse strings loose. But for the first time in seven months, they did not have extra purchasing power in November to shop with, as prices at the retail level rose by the same amount as worker earnings. That’s the first time since April that real worker earnings failed to increase from month to month. To be sure, one size does not fit all when it comes to measuring inflation and its impact on consumption. The 0.3 percent increase in the consumer price index during the month masks disparate price changes that impact the budgets of low-income households differently than those higher up the income ladder. Prices of medical care and food purchased for home use, for example, rose at a faster 0.4 percent during the month, which is more meaningful for lower-income households and seniors. By the same token, the relatively stronger 0.4 percent increase in airline fares reflects increased demand for travel, which is a discretionary expense incurred mostly by wealthier individuals who are better equipped to afford the higher prices.
The much-anticipated jobs report for November should not deter the Fed from cutting its benchmark rate by another quarter point at its upcoming December 17-18 meeting. For sure, a case can be made for staying put. The economy generated a tad more jobs during the month than expected, and the previous estimates of job gains for September and October were revised upward by a modest amount. A solid gain in payrolls last month was widely expected, as a big chunk of the 227,000 increase reflected the recovery of jobs lost due to hurricanes and strikes in October. Still, even after adjusting for these temporary shocks, the job market is looking stronger than it did back in September when the Fed, in response to a weak August jobs report, slashed rates by an outsized half point. Then, as now, job growth bounced back the following month and, as is likely again in mid-December, the Fed cut rates a second time at its subsequent meeting, albeit by a smaller quarter point.