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Dollar Finds Its Feet As Fed Holds Rates Steady

Dollar

The U.S. dollar has bounced off its 2-week low after the Federal Reserve maintained its dovish stance and kept interest rates unchanged.

The ICE Dollar Index, a measure that pits the greenback against a basket of six major currencies, turned higher on Wednesday trading after a FOMC meeting unanimously voted to keep the benchmark interest rate within its earlier range of 2.25-2.5 percent citing a strong economy and lack of inflationary pressure.

(Click to enlarge)

Source: Investing.com

Low inflation

Last week, the U.S.Commerce Department said that the economy had expanded 3.2 percent during the first quarter, exceeding virtually all prior estimates for growth.

But perhaps more importantly, fresh data coming on Monday has shown that core inflation-- as measured by personal consumption expenditure and excluding food and energy prices-- was tracking below the central bank’s target rate of 2 percent at 1.6 percent—a 19-month low.

Ok, if the economy is doing so well and inflation remains quite low, why not just go the whole hog and cut rates?

Well, the Fed does work in mysterious ways. Fed Chair Jerome Powell said we should not get too comfy because there’s enough reason to suspect that the slackening in price pressures is simply “transient” in nature. Specifically, the Fed introduced a less well-known metric officially known as the "trimmed mean PCE inflation rate.

"With core inflation, the Fed simply looks at core PCE,or personal consumption expenditures excluding food and gas because these tend to be highly volatile and not particularly good for predicting future inflation.

With the new metric, it goes even deeper.

This is how Powell described the new metric: "It cuts off the big movements on the upside and the downside, looks at the mean movements of inflation on the various product categories and service categories, and it didn't go down at all," he said at his press conference.

Related: Climbing Stocks Weigh On Gold, But A Turnaround May Be Near

Trimmed mean PCE inflation, therefore, is a more refined version of core PCE inflation where the most volatile components of PCE inflation are stripped off. Powell was even charitable enough to give us a glimpse of how this works in real-life:

"I will point to the case of cellphone services. Many of you will remember [that] in March 2017, there was a very low reading for cell phone services, mobile-phone services, and it was kind of a price war, and it dragged down core inflation for a full year, but it did not look like something that would be repeated."

In the current situation, Powell said falling prices for such outlays as tax preparation, TVs and jewelry, as well as rising prices of farm-produced food, watches and spectator sports, were all excluded.

Trimmed mean PCE inflation rate is a measure commonly used by the Dallas Fed but rarely by the Federal Reserve (at least not as explicitly as it has this time). It reminds us that the Fed can sometimes employ somewhat extraneous measures to justify policy steps in either direction. Citi economist Andrew Hollenhorst though has expressed support for the Fed’s change in tact, saying transitory drops in prices really are responsible for holding down year-on-year core inflation rates.

Nevertheless, the long and short of it is that a cut is not guaranteed in the coming months, and ‘‘real’’ inflation could very well start climbing so a resumption to a rate hike cycle remains a possibility.

Strong economy

Powell, though, did promise that the bank would indulge President Trump and investors with a rate cut if the inflation trend persists.

Indeed, the Fed did indulge the markets somewhat after announcing a small but significant 0.05 percentage point cut on banks’ interest on excess reserve (IOER) to 2.35 percent. U.S. banks are currently  holding $1.56 trillion at the Fed, with a significant portion considered excess. The Fed pays interest to banks on their reserves, which are considered a buffer--especially in times of economic uncertainty as part of its monetary normalization toolkit.

The Financial Services Regulatory Relief Act of 2006 authorized the Fed to pay banks interest rates on their reserves held with the bank, which it has done since Oct. 2008. The Fed pays banks interest on required reserves (IOR) and also on excess reserves (IOER). By lowering IOER, the Fed has signalled that it believes the economy is strong enough and is therefore encouraging banks to lend out more to businesses and individuals.

By Alex Kimani for SafeHaven.com

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