Moments ago the Fed released its semi-annual Monetary Policy Report which forms the basis of Janet Yellen's testimony to Congress next week, and while it does not traditionally discuss monetary policy it does provide a snapshot of the Fed's take of the economy and capital markets at any given moment. Here are some of the highlights courtesy of BBG:

• Fed says the outlook for higher inflation appears to be on track
• Fed sees labor market strong, hourly pay gains moderate
• Fed: fiscal policy likely to give GDP moderate boost this year
• Fed: prime-age labor force participation may continue to rise
• Fed: drag on GDP from higher oil prices likely to be smaller
• Fed says valuations still elevated for range of assets
• Fed: vulnerabilities from leverage in the financial sector look low
• Fed: commercial property valuations continue to be stretched

There were no major surprises in the 63-page report which remains consistent with the Fed’s current outlook which is that strong economic growth and low unemployment require rate rises but that a lack of severe inflation pressures means they can remain gradual.

"Economic activity increased at a solid pace over the first half of 2018, and the labor market has continued to strengthen. Inflation has moved up, and in May, the most recent period for which data are available, inflation measured on a 12-month basis was a little above the Federal Open Market Committee’s longer-run objective of 2 percent, boosted by a sizable increase in energy prices" the Fed said adding that the economy continues to be supported by favorable consumer and business sentiment, past increases in household wealth, solid economic growth abroad, and accommodative domestic financial conditions.

As a result, the Fed “expects that further gradual increases” in interest rates would be appropriate continues to oversee an economic expansion that is now the second-longest on record, a task complicated by the recent break out in global trade war.

Commenting on Trump's fiscal stimulus package, the Fed said that it likely contributed to a rebound in consumer spending from a sluggish start to the year and will likely provide a moderate boost to economic growth this year. This optimistic outlook of the U.S. economy was also referenced by Powell in an interview on Thursday in which he said he believes the U.S. economy remains in a “really good place” with recent government tax and spending programs set to boost gross domestic product for perhaps three years.

(Click on image to enlarge)

And while the prevalent message is "smooth sailing" ahead, the Fed flagged several areas of concern, as follows:

Oil prices.

Oil prices have climbed rapidly over the past year, reflecting both supply and demand factors. Although higher oil prices are likely to restrain household consumption in the United States, much of the negative effect on GDP from lower consumer spending is likely to be offset by increased production and investment in the growing U.S. oil sector. Consequently, higher oil prices now imply much less of a net overall drag on the economy than they did in the past, although they will continue to have important distributional effects. The negative effect of upward moves in oil prices should get smaller still as U.S. oil production grows and net oil imports decline further.

Inflation.

Consumer price inflation, as measured by the 12-month percentage change in the price index for personal consumption expenditures, moved up from a little below the FOMC’s objective of 2 percent at the end of last year to 2.3 percent in May, boosted by a sizable increase in consumer energy prices. The 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator of where overall inflation will be in the future than the total figure, was 2 percent in May. This reading was ½ percentage point above where it had been 12 months earlier, as the unusually low readings from last year were not repeated. Measures of longer-run inflation expectations have been generally stable.

Prime-age labor force participation.

Labor force participation rates (LFPRs) for men and women between 25 and 54 years old—that is, the share of these individuals either working or actively seeking work—trended lower between 2000 and 2013. Those trends likely reflect numerous factors, including a long-run decline in the demand for workers with lower levels of education and an increase in the share of the population with some form of disability. By contrast, the prime-age LFPR has increased notably since 2013, and the share of nonparticipants who report wanting a job remains above pre-recession levels. Thus, some continuation of the recent increase in the prime-age LFPR may be possible if labor demand remains strong.

Financial conditions.

Domestic financial conditions for businesses and households have generally continued to support economic growth. After rising steadily through 2017, broad measures of equity prices are modestly higher, on balance, from their levels at the end of last year amid some bouts of heightened volatility in financial markets. While longterm Treasury yields, mortgage rates, and yields on corporate bonds have risen so far this year, longer-term interest rates remain low by historical standards, and corporate bond issuance has continued at a moderate pace. Moreover, most types of consumer loans remained widely available for households with strong creditworthiness, and credit provided by commercial banks continued to expand.

The level of the dollar:

After depreciating during 2017, the broad exchange value of the U.S. dollar has appreciated moderately in recent months. Factors contributing to the appreciation of the dollar likely include moderating growth in some foreign economies combined with continued output strength and ongoing policy tightening in the United States, downside risks stemming from political developments in Europe and several EMEs, and the recent developments in trade policy. Several currencies appeared particularly sensitive to trade policy developments, including the Canadian dollar and the Mexican peso, related to the North American Free Trade Agreement negotiations, as well as the Chinese renminbi, which fell notably against the dollar in June.

On the risk of a spike in term premiums (i.e. what happens if the BOJ and ECB stop buying):

Treasury term premiums have increased modestly from the beginning of the year but remain low relative to historically observed values. Corporate bond yields and their spreads to yields on comparable-maturity Treasury securities have increased notably, but they continue to be low by historical standards. In particular, speculative-grade yields and spreads lie in the bottom fifth and bottom fourth of their respective historical distributions. In leveraged loan markets, issuance has been robust, spreads have reached their lowest levels since the financial crisis, and the presence of loan covenants has decreased further.

On the recent crash in EMs:

Investor concerns about financial vulnerabilities in several emerging market economies (EMEs) intensified this spring against the backdrop of rising U.S. interest rates. Broad measures of EME sovereign bond spreads over U.S. Treasury yields widened notably, and benchmark EME equity indexes declined, as investors scrutinized macroeconomic policy approaches in several countries. Turkey and Argentina, which faced persistently high inflation, expansionary fiscal policies, and large current account deficits, were among the worst performers. Trade policy developments between the United States and its trading partners also weighed on EME asset prices, especially on stock prices in China and some emerging Asian countries. EME mutual funds saw net outflows in May and June after generally solid inflows earlier in the year.

On Trade as a risk:

Globally, potential downside risks to international financial markets and financial stability include political uncertainty, an intensification of trade tensions, and challenges posed by rising interest rates.

Finally, the traditional warning on elevated asset levels which will naturally be ignored until it is too late:

Asset valuations continue to be elevated despite declines since the end of 2017 in the forward price-to-earnings ratio of equities and the prices of corporate bonds. In the private nonfinancial sector, borrowing among highly levered and lower-rated businesses remains elevated, although the ratio of household debt to disposable income continues to be moderate. Vulnerabilities stemming from leverage in the financial sector remain low, reflecting in part strong capital positions at banks, whereas some measures of hedge fund leverage have increased. Vulnerabilities associated with maturity and liquidity transformation among banks, insurance companies, money market mutual funds, and asset managers remain below levels that generally prevailed before 2008.

In other words, the Fed sees nothing to be worried about as it continues to hike rates, which have pushed the yield curve to a tiny 26 bps.

Full report link.