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Will the Fed Allow the Economy to Run Hot?

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The Fed has not signaled a desire to tighten. U.S. jobs data are encouraging. Yet inflationary pressures, while picking up, remain modest. Some evidence suggests the U.S. unemployment rate could fall further without triggering significant inflation. We think the Fed might be willing to let the economy run hot before raising rates. This mirrors developments elsewhere. Bank of England (BoE) Governor Mark Carney last week signaled the BoE may tolerate a period of above-average inflation.

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Market Realist – Encouraging economic indicators

As we saw in the first part of this series, strong US jobs data have enhanced the chances of tightening in the United States (IVV). However, sticky inflation, which remained well below the Fed’s target inflation rate of 2% despite the economic momentum, has weakened the case for a sharp interest rate hike.

Sticky inflation

According to the United States Department of Labor, consumer prices in the United States (IWF) (IJH) increased by a mere 0.8% in July year-over-year. This was below market expectations of 0.9%. It was the lowest inflation rate since December 2015.

Prices rose 1% each in June and May. Excluding food and energy, the core Consumer Price Index fell to 2.2% year-over-year in July from 2.3% in June.

Unemployment rate

The unemployment rate in the United States (IWD) stood at 4.9% in July, the same as in June. But it was higher than market expectations of 4.8%. Although the unemployment rate remained a bit higher than expected, companies are still hiring at a rapid pace. This could lead to a fall in the unemployment rate in the next few months.

Against this background, the Fed is likely to increase rates gradually while allowing the economy to strengthen further. In the United Kingdom (EWU), inflation inched up to 0.6% in July, the highest level this year. It’s expected to rise further in the last quarter. Despite the rise in inflation, the Bank of England is still likely to follow expansionary monetary policies to stimulate growth. The Fed will likely follow the same path.

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