The Fed Paints Itself (Further) Into A Corner — But We Can Still Profit…

Last week, traders focused on the Federal Reserve. The Kansas City Fed hosted its annual conference at Jackson Hole. Like so many other events, this was a virtual conference. That means, during the breaks, there were no discussions between the world’s leading economists.

In the past, when those discussions could take place, I think Fed officials would be open to new arguments. Now, without the possibility of a random discussion over a cup of coffee, everyone probably left the conference with the same opinions they started with.

That seemed especially true of Chair Jerome Powell, who used his speech to explain that inflation is transitory, and the Fed’s policy is appropriate for the current environment.

According to the The Wall Street Journal

Federal Reserve Chairman Jerome Powell reaffirmed the central bank’s emerging plan to begin reversing its easy-money policies later this year while explaining in greater detail why he expects a recent surge in inflation to fade over time.

At the Fed’s meeting late last month, “I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace” of the Fed’s $120 billion in monthly asset purchases this year, Mr. Powell said Friday.

Since that meeting, the economy has seen “more progress in the form of a strong employment report for July, but also the further spread of the Delta variant” of the Covid-19 virus, Mr. Powell said Friday morning at a virtual symposium hosted by the Kansas City Fed.

Mr. Powell’s remarks didn’t indicate that concerns over the Delta variant would lead the Fed to delay its plans to reduce asset purchases this year. “While the Delta variant presents a near-term risk, the prospects are good for continued progress toward maximum employment,” he said.

The Fed’s next meeting will be Sept. 21-22, and several Fed officials have said they would favor beginning to taper bond purchases shortly after that meeting if hiring remains strong.

Powell also argued that inflation is transitory. He understands that core inflation, which excludes food and energy prices, increased 3.6% in July from a year earlier. That measure has long been the Fed’s preferred inflation metric.

The consumer price index is even higher, at 5.3% in July. White House economists expect inflation to come in at 4.8% in the fourth quarter of this year before dipping to 2.5% in 2022.

In his speech, Powell noted…

…inflationary pressures still appear likely to largely reverse on their own…. He cited a record dating to the 1950s that “taught monetary policy makers not to attempt to offset what are likely to be temporary fluctuations in inflation,” he said.

“Indeed, responding may do more harm than good, particularly in an era” when interest rates are more likely to be pinned near zero.

Because it can take a year for monetary-policy decisions to ripple through the economy, tightening policy due to temporary factors raises the risk of an ill-timed move to unnecessarily slow the economy, leading to less hiring and inflation that remains too low, Mr. Powell said.

“Today, with substantial slack remaining in the labor market and the pandemic continuing, such a mistake could be particularly harmful,” he said.”

In his review of recent inflation developments, Mr. Powell suggested inflation was likely to moderate in the coming months because prices of certain items, such as used cars, that contributed strongly to the recent price surges have begun to decline.

So far, there is little evidence that inflation is rising beyond a “relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy,” he said. Mr. Powell said he saw little evidence of wage increases that might lead to excessive inflation, for example.

Mr. Powell also suggested that long-running forces such as globalization and technology that have held down prices, especially of consumer goods, over the past 30 years are likely to continue once the pandemic subsides. “There is little reason to think” that global disinflationary forces “have suddenly reversed or abated,” he said.

Like the economists attending the presentation, my opinion didn’t really change. I believe the Fed has painted itself into a corner. If anything, the speeches made the corner a little smaller.

The Fed’s balance sheet is equivalent to more than a third of GDP.

Source: Federal Reserve

The Fed has little room to attack the next crisis using traditional tools. The Fed could also create the next crisis by trying to decrease its balance sheet, so they will act with caution.

The next Fed meeting is scheduled for September. I expect the Fed to announce plans to gradually begin tapering later in the year after that meeting. It will be small, and traders should be able to shrug off the news. But the Fed will retain flexibility with Congress threatening to spend trillions of dollars that will require someone to buy Treasuries. The Fed will retain flexibility to allow Congress to spend recklessly.

How I’m Trading Right Now

Once again, in the short run, I’m focusing on my indicators.

These macro developments can give us an idea of the picture in the long run. But in the meantime, there will be opportunities for us to make successful trades…

Last week’s action turned my Income Trader Volatility (ITV) indicator bullish as shown in the bottom panel of the SPDR S&P 500 ETF (NYSE: SPY) chart below.

ITV is similar to VIX in that it rises as prices fall. Its current position, with the indicator (red) moving below its moving average (blue), points to continued strength in stocks.

Our last chart this week shows my Profit Amplifier Momentum (PAM) is also improving.

PAM is designed as a short-term indicator. Its recent movement is a potential indicator of strength.

Based on my indicators, it looks like the Fed may have engineered a rally in the S&P 500. Time will only tell how long it will hold. But over at my Maximum Income premium service, we are using a strategy that can protect us from any potential downside…

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