ANALYST VIEW-Fed sees steady economy, only "moderate" financial vulnerabilities


NEW YORK, July 7 (Reuters) - The U.S. economy continues to churn out jobs and grow at a steady pace, with investment and consumer confidence both healthy and only moderate signs of risk in financial markets, the U.S. Federal Reserve said on Friday in its semiannual report to Congress.

Key points

With stock markets near record levels, and interest rates and credit conditions still loose, the report gave detailed attention to whether the financial system and bond markets posed any particular threat to the country's eight-year economic expansion.

JIM PAULSEN, CHIEF INVESTMENT STRATEGIST AT THE LEUTHOLD GROUP IN MINNEAPOLIS, MINNESOTA: I dont see anything different from what the Fed has been saying already. The economy continues to be okay. Its not overheating or under-heating. The implicit message is that we are on track to raise interest rates and to shrink the balance sheet, not because the economy is overheating but we want to normalize monetary policy.

It is their jobs to cite risks in the economy and markets. To me when they say moderate vulnerabilities in the financial system, its a benign statement. If they are alarmed, they would be more aggressive language like elevated. They are recognizing the pickup in subprime credit card and auto loan delinquencies which they probably heard from the private sector.


My general sense is a little bit of a defensive tone with respect to particularly the lower inflation numbers and the weaker compensation gains. Particularly the section on talking about the rules-based decision-making, the fact that there a lot of complicated inputs and to paraphrase cant be totally restrained by rules-based framework, suggests that they still are firmly of the mind that they need to normalize policy and intend to continue with steps that way not only on the balance sheet, but also likely more interest rate hikes unless they get some clear indications that the wheels are falling off the economy.

The one thing that stuck out to me was, too, the section that really focused on some of the portions of the labor force ... that have not changed significantly relative to what we saw before the last recession, it seems like they are de-emphasizing their role as chief employment officers in favor of some of the more monetary goals that are on their plate."

"They mentioned that the VIX is at historically low levels. One would think that they might be somewhat concerned about the complacency in the markets given that valuations have risen, but you dont get that tone from what they are saying.

"The general tone of the overall report was that: 'We think its time to normalize, we intend to do so, here are some of the reasons for it and here are some of the defenses against our critics."'


They did mention early on in the summary that inflation has softened in the past few months. They put that up pretty front and center in the summary.

They still find themselves in this frustrating conundrum that inflation isnt rising despite it seeming that the labor market is near full employment, and without material inflation how much can they ratchet up the Fed Funds rate. That's probably a dovish tilt in the report and probably suggests they may pause in continuing to hike rates in the foreseeable future, maybe the next six months.

"I think some of the committee, despite the more hawkish tone recently, are starting to be more sensitive to the fact that the fact that inflation is not materializing the way the market thought this year.

This is not a high impact report for traders. There's nothing in there that is a big surprise.

For the most part, they dont have any unique insight into the stock market. In the last few years there have been moments when the Fed has commented on stock prices and clearly in a few instances there have been more cautionary type messages about elevated prices. They have mentioned in the past that they have observed that equity prices are high but that hasnt translated into any prescient call." (Americas Desk)