Don’t count out the Fed. With all the emphasis on the new administration’s fiscal policy, the release of the Federal Reserve’s meeting minutes this week came with little fanfare. During the 15 minutes of fame at release, the primary point to highlight is the comment by Fed officials that rate increases are coming “fairly soon.” Of course, what does fairly soon mean? The next meeting of the interest rate setting body is in March but that is widely anticipated to be a non-event since it is not accompanied with a press conference. While no-action is still the best bet, it stands to reason that there is a complacency about the Fed’s willingness to act in 2017. As we have noted in prior write-ups, a consistency in President Trump’s suggested policies is the upward pressure to inflation. Despite the massive increase in money supply after the financial crisis, inflation has been difficult to muster as segments of the economy (in particular households) deleveraged and the “velocity of money” (i.e. how many times each dollar changed hands) fell as activity did. However, at this point the deleveraging of households has slowed considerably while government has increased leverage significantly followed by corporations seeking to issue low cost debt. With deficit-spend policies anticipated, a pick-up on the fiscal side may get the animal spirits on the rise increasing activity/velocity. Recent economic readings in the US have shown a firming of the inflationary trend which has not escaped the data-dependent eyes of the Fed. The question is: does the Fed act early to keep inflation under control and risk de-railing growth too soon (through increased cost of capital and likely a strengthening US Dollar) or do they let the fiscal party get started and we see some uncomfortable inflation numbers in the rear-view mirror before stepping up?
The potential impact to asset classes is meaningful. Act too fast and the market will think growth will choke causing equities to swoon and bonds to rally. Act too slow and inflation could approach the historical tipping point around 4% which is where equity P/E valuations get crunched at the same time the rise in bond yields drags returns negative. Good reasons to stay diversified across equities, fixed income, and real assets. Monetary policy hasn’t lost its power even if fiscal is getting all the limelight.