Financial market volatility acknowledged
The FOMC staff review indicated that US financial markets have been turbulent since the last meeting, which resulted in increased equity market volatility (VXX) and lower equity (VOO) asset prices. The reason cited for the increased equity market volatility was the surprising uptick in average hourly earnings in the January employment report, which made investors concerned about higher inflation and the interest rate increase. In the meeting, FOMC members acknowledged the decline in asset valuations and highlighted the downside risk that comes with high asset valuations and low-interest rates—a signal that they’re looking to gradually increase interest rates.
Market acceptance of the December rate hike
The staff review indicated that market participants viewed the inter-meeting communications and the January FOMC meeting statement minutes as a signal of a stronger economy. The staff review indicated that fed fund futures are pricing a 70% probability for another rate hike in June. The expectations for rate hikes in 2019 and 2020 have moved marginally higher, as derived from the overnight index swap quotes.
Financing conditions for US businesses and households remained accommodative and continued to support economic growth. Credit conditions for the commercial real estate and commercial mortgage-backed securities (MBB) were accommodative, while mortgage rates have moved higher—in line with long-term (TLT) Treasury securities.
US financial system’s vulnerabilities
The FOMC staff review included a report on the US financial system’s vulnerabilities, which were moderate. The report said that financial stability could be disturbed if the trade conflicts escalate. The other risk was the overshoot of inflation (TIP) due to increasing wages, which could lead to faster-than-expected rate hikes in the future.
Next, we’ll discuss FOMC members’ inflation outlook for the US economy.