Market and economic update: The Fed announces its next round of tapering

The attention of investors last week was focused on Federal Reserve policy and the evolving conflict in Iraq and Ukraine.

  • The Federal Open Market Committee (FOMC) meeting concluded with an announcement of another $10 billion in tapering of bond purchases. Given the comments made by Janet Yellen at the press conference, the market seemed to believe she was leaning toward a dovish monetary policy. In our view, the Fed will likely complete tapering in October and may increase the Fed Funds rate in the second quarter of 2015.
  • The conflict in Iraq continued with Sunni Muslim forces and Islamic State of Iraq and Syria (ISIS) controlling Mosul and key border crossings with Syria and Jordan. Shiite Muslim militias seem to be mobilizing to defend key mosques and the southern region of Iraq in support of government troops. Kurdish militias have secured Kirkuk and seem to be consolidating authority over the Kurdish region of Iraq. This is likely to be a longer conflict as long as oil infrastructure in the south remains in operation. We believe the likelihood of involvement of U.S. forces or air strikes is small.
  • The Russia-Ukraine conflict continues at a simmer, with Russian troops massed on the Ukrainian border and further conflict with pro-Russian forces in Ukraine. As long as Western forces do not get directly involved, the likely outcome is for a government in Ukraine that is friendly to Russia.

In the United States, data on inflation and industrial production seemed to indicate that U.S. economic growth is improving. Industrial production for May rose 0.6%, with year-over-year growth reaching its highest level since 2012. Consumer prices in the United States rose 0.4% for May, a gain of 2.1% over the past year, sparking market concerns that the Fed may be forced to increase interest rates in the near term.



The Fed focuses on Personal Consumption Expenditures (PCE) inflation measures, which are currently lower than the Consumer Price Indexes (CPI) calculation, mostly due to the mix of goods measured. In the consumer price calculation, shelter and energy were the primary drivers of higher inflation. We believe these factors are unlikely to create a sustained increase in prices. Shelter price increases are typically led by rising home prices. The pace of increase for home prices is slowing, indicating the gains in shelter prices may slow as we get through this year.

Energy prices have increased modestly along with geopolitical risks. U.S. oil and natural gas production has tempered some of the gains in energy prices. Any easing of geopolitical tensions should also ease energy inflation. We believe the most important driver of long-term inflation is wage growth, which allows consumer spending to expand. Although employment data is improving, wage growth remains modest, which leads us to believe there is little to support a looming inflation surge.

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Robert L. Haworth, CFA, is a senior investment strategist and Darrell Behnke is the Madison market leader for the Private Client Reserve of U.S. Bank. 

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