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Economic Monitor – Weekly Commentary
by Eugenio Alemán

Is this what the Dr. ordered?

January 17, 2025

Chief Economist Eugenio J. Alemán discusses current economic conditions.

When we hear the discussion about what the Federal Reserve (Fed) has to do or doesn’t have to do over the next several months there seems to be a serious misunderstanding of the objectives of monetary policy, at least in the US. We understand that the monetary policy playbook since the Bernanke Fed and the Great Financial Crisis has changed considerably due to the introduction of many more monetary policy instruments that have helped the Fed stabilize the economy as well as the financial system. One such instrument being Quantitative Easing/Tightening and other emergency liquidity programs, etc. Many argue, and we agree with those arguments, that some of the new instruments of monetary policy introduced during this period cloud the line or distinction between monetary policy and fiscal policy. But that is a topic for a longer discussion.

For this report, the basic tenets of monetary policy have not changed that much even with the introduction of so many new instruments for conducting monetary policy. That is, in the US, the Fed changes short-term interest rates, i.e., the federal funds rate, to influence longer-term interest rates. That is, in theory, a lowering of short-term rates lowers longer-term interest rates, caeteris paribus, that is, other things remaining constant. But what many seem to forget is that other things do not remain constant.

Once again, in the US, the prime objective of monetary policy is to affect mortgage rates, which typically follows the 10-year Treasury yield. But the yield on the 10-year Treasury has more determinants, other than the federal funds rate. It also depends on the supply/demand for Treasuries, the term-premium, inflation expectations, economic growth, etc. And all of these “other things constant” have not remained constant. Thus, instead of coming down, the yield on the 10-year Treasury has gone up and mortgage rates have followed suit.

The current environment is, in some sense, what the ‘Dr. ordered’ for the Fed (and for the US Treasury). Why? Because the Fed could continue to lower interest rates without fear of reigniting inflation through growth in lending, especially in the mortgage market. That is, the fact that the long end of the yield curve has steepened so much will prevent mortgage lending from becoming a risk for inflation. At the same time, the US Treasury can take advantage of lower short-term interest rates to lower the cost of refinancing the US debt because shorter-term government paper does follow the federal funds rate more closely than longer-term rates.

This week’s inflation reports, both the CPI and PPI, were supportive of the Fed. The PPI for services was lower than expected while the core CPI was also lower than expected. Although the headline rate of inflation increased, the Fed should be okay with it as long as the increases in food and energy prices seem not to be spilling into higher core prices. If this continues going forward, the Fed will be in a good position to lower rates this year.

We are not saying that the Fed is going to lower interest rates immediately and/or that risks to higher inflation do not remain elevated, especially due to policy uncertainty, but if we were members of the Federal Open Market Committee we would align with the doves in the committee, especially toward the end of the first half of the year.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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