What will the Fed do next?

As the latest FOMC meeting looms, we look at the current state of play in US economic data, and examine the current breakout in the dollar index.

Federal Reserve
Source: Bloomberg

This week’s Federal Reserve (Fed) meeting is not expected to be a blockbuster, but it will shed further light on a central bank that continues with gradual tightening even as it sends a clear message that above-target inflation remains acceptable.

Fed Funds Futures currently suggest a 47.6% chance of four rate hikes this year. We’ve already had one, so at present three more would carry the interest rate to 2.5%. US growth was 2.3% for the first quarter (Q1) according to initial reports, and while this is slightly weaker, it remains above the trend. As a result, the Federal Open Market Committee (FOMC) can stick to its optimistic view of the situation overall. Core inflation has strengthened as well, breaking above the 2% level for the first time since early 2017.

There are two factors that will continue to bother the FOMC. One is the possibility of a strong move higher in inflation thanks to the tax cut plans enacted by the White House. Jerome Powell’s predecessor, Janet Yellen, was already sounding a warning on the merits of engaging in more accommodative fiscal policy even as the economy improved - ‘counter-cyclical’ policies as they are known - and the continued increase in the Federal budget deficit will also concern other Fed members.

The other big unknown is the impact of trade wars. This poses the biggest risk to economic growth, since a full-blown trade war would make itself felt in consumer spending, employment figures and wage data. For now, the situation has calmed, but there are still plenty of elements that need resolving.

Despite a trimming of short positions over the past few weeks, the overall market remains significantly net short on the US dollar (USD). The latest bounce has a whiff of short-covering about it, but with the overall market still around $20 billion short of the greenback, the rebound in the price may be brief.

Last week saw the US dollar index break the downtrend line that has held since the end of December 2016. If this marks the beginning of a significant move then we would look to $91.93 and $92.75 as near-term targets, with the 2017 peak at $94.93 above this. A push back below the trendline would need a close back below $90.81, and then target $89.71 and $88.12.

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