A More Hawkish Fed Could Have Unintended Market Effects

By The FedFOXBusiness

Stockman: Recession by the end of year

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Stockman: Recession by the end of year

Former Reagan budget director David Stockman discusses how increasing government debt will result in the next president inheriting a recession.

The Federal Reserve has exercised extreme caution when it comes to telegraphing to the markets its intent for monetary-policy changes. But economists warn that as the central bank moves closer to pulling the trigger again on raising rates, it could unintentionally change the delicate dynamic it’s put in place.

Back in December, the Fed began its path for normalizing monetary policy when it raised rates for the first time in nearly a decade. At that time, the U.S. central bank said it expected to raise rates four more times by the end of 2016, but was forced to revise that forecast down to just two rate hikes by the end of the year due to unforeseen global market events.  

Minutes released after its two-day policy setting meeting last month showed the Fed actively preparing the markets for a June or July rate rise. It cited better economic conditions and a decrease in global market concerns and volatility as the main drivers for moving rates higher.

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In the week following the minutes’ release, fed funds futures – a tool used to predict the market’s expectations of future changes in monetary policy – have ratcheted up forecasts for a summer rate hike. Odds for a move in June went from single digits to 34%, while expectations for at least one increase in rates stand at 57% in July, and 80% by the end of the year in December.  

But it’s not just as simple as the Fed making a move to set higher rates. Market expectations naturally tighten financial conditions, a phenomenon economists at Deutsche Bank said could interrupt the Fed’s plans, citing 2013’s so-called taper tantrum in the markets as an example of expectations disrupted by changing financial conditions.  At that time, equity and bond markets showed a sudden and sharp reaction to comments made by then-Fed Chairman Ben Bernanke that the central bank could slow the rate of its bond purchases.

The Deutsche Bank economists, in a note, said if the Fed continues with its increasingly hawkish tone without better macro-economic data, they expect interest rates to move higher while the dollar gains more strength and risk assets to come under pressure – ultimately naturally tightening financial conditions.

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