• Nearing normalization / shutdown shuffle

    “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

    – from the September 17 FOMC policy statement


    The key line that was added to the Fed’s policy statement suggests a sharper focus on what’s happening in the rest of the world, but let’s be clear. The Fed is not reacting to overseas developments per se, but to what shifting global economic and financial conditions mean for the U.S. economy. In focusing on the Fed’s decision to delay policy normalization, investors have ignored the increased risk of a government shutdown.

    Fed officials remain optimistic about the domestic economy. Net exports may be soft, but policymakers anticipate moderate growth in consumer spending and business fixed investment. Inflation is low, due largely to transitory forces, according to the Fed, and is expected to move toward the Fed’s 2% goal “as the labor market improves further and the transitory effects of declines in energy and import prices dissipate.”



    The dots in the dot plot drifted a bit lower, a consistent theme over the last year. There was no consensus about the likely year-end federal funds target rate in 2016 and 2017. All but four officials expect a rate increase this year (the Federal Open Market Committee meets in late October and mid-December). One official, almost certainly Minneapolis Fed President Narayana Kocherlakota (who will soon leave the Fed), is calling for a negative federal funds target range. That isn’t as crazy as it sounds. A number of other central banks have gone to negative rates. A longer trend in low inflation and a decline in inflation expectations implies a higher real interest rates – that is, even if nominal rates are unchanged, monetary policy tightens as inflation falls. The FOMC noted in its policy statement, “market-based measures of inflation compensation have moved lower.”

    Some of the narrowing in inflation compensation could be a flight to safety in Treasuries, but an extended low inflation outlook should be a serious concern for the Fed. Officials have consistently underestimated inflation over the last several years.



    While market participants have been focused on the Fed, another concern has been growing in recent weeks. The federal fiscal year ends on September 30. Congress has yet to come up with the appropriation bills or a Continuing Resolution that would fund the government into October. Without that, a partial government shutdown looms. Notices were sent out last week to government agencies to prepare for a possible shutdown. While there is still time, the odds appear to be better than even that we’ll see a shutdown.

    Tea Party Republicans, who drove a two-week shutdown two years ago, are threatening to shut down the government again unless funding for Planned Parenthood is removed from the budget. Controversy over some edited videos, purporting to show hired actors acquiring fetal tissue samples, has heightened the risk of a shutdown. The non-Tea Party Republicans are having trouble controlling the process and there is some chance that House Speaker Boehner may lose his position.

    Even if Congress manages to fund the government in the near term, there is a possibility of a government shutdown over the debt ceiling. Treasury has already reached the debt ceiling, but it can dodge that constraint for a while through some creative accounting. Such actions have limits, and the federal debt limit is now expected to become truly binding in early December.

    A short government shutdown need not be too unsettling for investors (“been there, done that”), but it’s not going to help. In her post-FOMC press conference, Fed Chair Janet Yellen said that the possibility of a government shutdown played no part in the Fed’s policy deliberations.

    Contributed by Raymond James
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