The Fed is likely to leave key interest rates unchanged at its meeting next week. This does not mean, though, that the tightening process has fallen at the first hurdle. The economic recovery continues and inflation pressure is slowly rising. We indicate that higher inflation pressure is to be expected in services in particular.
The Fed is therefore likely to raise interest rates more (twice) than the markets currently expect. This will support the dollar and cause yields to rise. US economy under stress .
.. There can be no doubt that the US economy is encountering headwinds. Together with the sluggish growth in the global economy, the strong dollar is dampening export demand, and financial markets have become more unsettled. The Cleveland Fed’s Financial Stress Indicator has briefly shown its highest warning level (“significant risk“), similar to 1998 during the emerging market crisis and the failure of the LTCM hedge fund, and again in 2011/2012 amid the sovereign debt crisis in the euro zone (chart on the front page).
At the same time, business surveys reveal worry lines on the faces of purchasing managers. The manufacturing ISM has been below the 50 level for five months, indicating falling business activity, and its counterpart for non-manufacturing sectors recently fell for the fourth time in a row.
Against this backdrop, the Fed is set to leave rates unchanged next week but will leave the door open to resume the tightening process later this year. … but the economy is robust … That said, current concerns about the economy should prove increasingly unfounded in the coming months.
Although the ISM indices normally depict economic growth quite well, they have sent out wrong signals occasionally in times of pronounced financial market turmoil. During the emerging-market crisis in 1998 for example, the indices dropped similarly sharply to now, without economic growth decreasing markedly.
And during the sovereign debt crisis of 2011/12, our model based on the two ISM indices clearly underestimated growth (chart 5).4 In the present environment, the decline in the ISM indices is attributable, at least in part, to the turbulence on financial markets; according to our model, the ISM data for January and February show a rise in real GDP in the first quarter of only 1.2% versus the previous quarter, which would actually mean a contraction relative to the fourth quarter