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To the Surprise of No One

Updated: Dec 7, 2023

The Federal Reserve Holds Rates Steady While Banks and Oil Do Its Work for It

A Soft Landing, the El Dorado for Central Bankers, Seems Tantalizingly Close

Surly bonds

The Federal Reserve left short term interest rates unchanged at 5.25-5.5% at its meeting yesterday in a sign that it is comfortable with the pace of inflation deceleration and the level of economic growth. The non-move move was widely expected in the markets, as core inflation has trended downward, the labor market has softened, and economic growth has persisted. Though consumer spending and business investment have been surprisingly resilient given the level of interest rates, the Fed sees its interest rate policy working through the credit channel.

Behind the scenes at the Federal Reserve
"Hey Philip, is it 'Dynamic-stochastic-general-equilibrium-model-PJ-FINAL.xlsx', or 'Dynamic-stochastic-general-equilibrium-model-PJ-LAST.xslx'?" Also, using reams of paper to raise a monitor gets a thumbs-up.

Banks have been reducing their lending, resulting in a contraction in the money supply

Monetary policy works through several different channels, the most important of which are the interest rate channel and the credit channel. When the Fed raises or lowers interest rates, it directly affects the borrowing calculus that businesses and individuals make. Higher rates make borrowing more expensive, and therefore there is less borrowing. That constrains the money supply, which in turn slows economic growth. The credit channel, on the other hand, is an indirect method of monetary policy transmission whereby banks change their calculus about how much money to lend to businesses and individuals. Less lending constrains the money supply, which in turn slows economic growth.

Another reason why the Fed felt comfortable in sitting tight was that the price of oil has recently increased due to production cuts by Russia and Saudi Arabia, which has encouraged the price of oil to rise to $97 a barrel as of the end of the day Tuesday.

Oil is trading higher once again following production cuts

Higher oil prices mean higher inflation, so why doesn't the Fed increase rates to attempt to quell demand for oil and thus its high price? First, energy supply is inelastic in the short term, so it is hard to use tools that feature long and variable lags to try to influence it. Second, the Fed uses measures of core inflation--which exclude volatile categories like food and energy--to guide its policy, so a spike in oil prices is less likely to affect its judgment as to what the right level of interest rates are to achieve the level of economic activity they desire. Third, the Fed is currently pursuing a restrictive monetary policy, meaning they want the economy to slow so that change in the general price level reverts to its 2% target. Higher energy prices reduce economic activity as drivers drive less and shippers ship less due to the elevated cost of doing so, thus applying a brake to economic activity.

So, the Federal Reserve is content to sit pat and wait for the effects of its interest rate policy to translate into lower borrowing and lending, and for the price of oil to reduce demand as the economy slows. Should the US Congress fail to pass a spending bill and another government shutdown occur, economic activity would likewise regress, and the expected final rate hike of this campaign would be in doubt.

The European Central Bank Examines Its Monetary Policy and Finds It Wanting

Meanwhile, back in Europe, inflation remains high and looks entrenched, the economy is struggling, and rates can only go one way

ECB President Christine Lagarde indicates where she thinks EU rates are headed

Inflation has receded a bit in Europe, moving from 5.3% to 5.2% in the most recent measurement periods. Despite their similarities as Capitalist Democracies, there are still quite a few differences between the United States and its allies on the European continent. While the US is willing to tolerate greater poverty and greater concentration of wealth, the EU has a different social contract that provides for economic stability for its least fortunate citizens during times of economic contraction (income transfers), and a ceiling on prosperity for its most fortunate during times of economic expansion (taxes). Additionally, the EU has a longer and more-established history of collectivism in its labor markets. Wages adjust more frequently and rapidly to increases in price, and the Labor Share is typically higher than it is the in United States.

At 5.2%, EU inflation remains stubbornly high. Dotted line represents 2% policy target

Inflation has been stickier in the EU, though much of this is due to the economic disruptions that occurred as a result of Russia's invasion of Ukraine and concomitantly high energy prices. That said, Labor in the EU enjoys more leverage over Capital than it does in the United States, and so we should expect to see general price inflation flow through to wages more directly and be stickier than in the United States. There's not much difference currently between core and headline measures of inflation in the EU, though that is about to change with the recent rise in oil prices. The European Central Bank opted for a hawkish response to current price trends by instituting a quarter-point raise in the interest rate to a historical high of 4%.

The EU economy registered no growth in the second quarter

As growth is already at a standstill across Eurozone, but inflation remains stubbornly high, policymakers there face a much more acute tradeoff between economic growth and price stability. Like the United States, there is ability and appetite to keep raising rates if core inflation fails to move toward the 2% policy rate, but it will come at an increasingly higher cost.

Europe stocks haven't seen the same runup in price that their co-Atlanticists have

Still, when compared to the US equity market, European stocks look like a value. They boast a better Price/Earnings ratio (12.3), and consequently a more attractive earnings yield (8.13%) that well clears the risk-free rate and provides real compensation for assuming equity risk (an equity risk premium of 4.75%). Given the extraordinarily strong US dollar and the likelihood that its value will decline from here, EUR-denominated assets look particularly attractive, as they have the potential to provide additional return from the appreciation of the EUR relative to the USD. Although rates are higher in the US, it is the direction and rate of change in interest rates and inflation from here on out that will determine the direction of exchange rates. As inflation is more likely to rise in the US and fall in the EU, and rates are more likely to rise in the EU and fall in the US, the risks seem weighted toward the downside for the US dollar.

Nonetheless, the strength of economic growth is a wild card: if the US continues to be the only beacon of growth among the world's major economies, or if the Eurozone continues to contract from here, then the flow of investment dollars may continue to benefit the US equity market and dollar in the short term. Events in Ukraine also exert an outsized influence on European economies. Should Ukraine experience a convincing breakthrough, or Russia suffer an impairment of its ability to hold ground, the consensus around the level and direction of European growth could precipitously change. As these developments take place, or fail to reify, we will continue to keep our fellow travelers apprised.

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