Is this what the Dr. ordered?

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.

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Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is 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.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

Employment cost Index: The Employment Cost Index (ECI) measures the change in the hourly labor cost to employers over time. The ECI uses a fixed “basket” of labor to produce a pure cost change, free from the effects of workers moving between occupations and industries and includes both the cost of wages and salaries and the cost of benefits.

US Dollar Index: The US Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the

U.S. dollar gains "strength" when compared to other currencies.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.

Producer Price Index: A producer price index(PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

Conference Board Coincident Economic Index: The Composite Index of Coincident Indicators is an index published by the Conference Board that provides a broad-based measurement of current economic conditions, helping economists, investors, and public policymakers to determine which phase of the business cycle the economy is currently experiencing.

Conference Board Lagging Economic Index: The Composite Index of Lagging Indicators is an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

New Export Index: The PMI New export orders index allows us to track international demand for a country's goods and services on a timely, monthly, basis.

Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

Source: FactSet, data as of 12/6/2024