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Implications for the Impending Rate Hike

ResponsiblyIrresponsible
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12/12/2015 10:01:49 PM
Posted: 12 months ago
So I'm with Tim Duy on this: if you've been tracking this stuff and still don't think that a rate hike is imminent, you're delusional, and will receive a warm awakening come Wednesday of this week.

It's happening: deal with it. Even though oil recently fell to a 7-year low in the aftermath of the OPEC meeting; credit spreads are on the rise; and high-yield ETF's are selling off like hot potatoes, it's happening.

Yes, I know that sounded facetious. More likely than not, those are viewed as "corrections" or "transitory noise" that the Fed would want to look through. For instance, here's a very common model for valuing discounted cash flows, called the Capital Asset Pricing model (CAPM):

k = rf + Beta * (rm - rf)

k = required return
rf = risk-free rate
Beta = regression coefficient relating a 1 percentage point change in market returns relative to the returns on an individual security
rm = expected return on individual security
rm - rf = risk premium on individual security
Beta * (rm - rf) = risk premium for market

So, as the Fed raises rates, we expected "k" to rise, as the risk-free rate (we can think of this as the fed funds rate or shorter-term Treasury bills that generally move in tandem) rises. Because returns are inversely related to prices, a rise in "k" means a fall in prices. This is for one security, but if we aggregate this to the entire market of securities, the trend is essentially the same--sans financials, whose share prices would tend to rise as the yield curve steepens (though due to the flattening on the long end we've observed recently, they'll probably take a beating).

So we should expect volatility. The Fed would ignore it, as well they should (note: this isn't an endorsement of a rate hike: there are other, better reasons for not hiking). In fact, there's a recent paper from Stein and Sunderam out of Harvard that fleshes out this thought process:

http://www.people.hbs.edu...

The general thrust is this. Financial markets are generally speaking efficient--e.g., we assume the efficient markets hypothesis (EMH), which stipulates that current market prices are based on all available information. Therefore, prices only react to perceived surprises. That's why the rate hike on Wednesday won't have much of an effect on markets: it's already priced in (though more on this later).

So, because financial markets are basing current pricing on their perceptions on what the Fed will do, they tend to react to data releases. Let's distill the Fed's reaction function into a very simple Taylor Rule. This is very, very basic, especially with the funds rate at zero (and, in fact, there are a whole lot of different specifications of this that might perform better: see Gust, Johannsen, and Lopez-Salido (2015): http://www.federalreserve.gov...), but we care about the principal here.

So, here's the reaction function:

FFR = F (Y*, Pi - Pi*) = r* + pi + 0.5 (Y*) + 0.5 (pi - pi*)

FFR = current fed funds rate
r* = Wicksellian equilibrium real interest rate, that this very simplistic model assumes to be a constant intercept term at 2 percent
pi = current inflation rate (let's use year-over-year core PCE inflation)
pi* = Fed's inflation target at 2 percent, which we'll assume is in terms of core PCE (in reality, it's in terms of headline, though core is used a shorter-run smoothing mechanism to filter out the volatility in energy and food price we tend to observe).
Y* = output gap = [((Y - Y-potential) / (Y-potential)) * 100], where Y and Y-potential are levels of current real and potential real GDP

In other words, the current federal funds rate is a function of the current observed output gap--insofar as we can observe an output gap--and inflation gap.

In reality, we can make this a bit more complex: markets might perceive an *inertial* coefficient in the Fed's reaction function. In other words, the Fed might put weight on a lagged value of the fed funds rate so that it moves in smaller increments: it's decisions are based a bit more on where the funds rate was and a bit less on movements in goal variables.

We can re-do our above model with the aid of a smoothing parameter. Assume that "w" is our inertial coefficient (it helps if we think of this basic inertial Taylor Rule as a regression, though assume away the residual, because we live in the land of "make believe"):

FFRt = (1 - w) [r* + pi + 0.5 (Y*) + 0.5 (pi - pi*)] + w * (FFRt-1)

FFRt-1 is the lagged value of the funds rate and FFRt is the current funds rate. Stein and Sunderam, examining the literature, find that historically w is about 0.85. Narayana Kocherlakota has recently argued that this inertia in the Fed's reaction function is largely to blame for the Fed's unwillingness to respond aggressively to the financial crisis: its high inertial coefficient inhibited it from responding to perceived changes in the data, and the fact that current policy was based on past policy culminated in a snowball effect of overly tight policy, especially as the data weakened largely as a function of the Fed not doing enough. (This is one of those rare cases that Ted Cruz was right, though for the wrong reasons--and his "solution" would only make this problem infinitely worse).

So, back to the argument:

If markets perceive a high inertial coefficient in the Fed's reaction function, any move by the Fed is seen as suspect relative to what they perceived the Fed wants to do, based on the economic fundamentals--in reality, due to policy lags and the importance of expectations, the actual reaction function probably used "t+1" terms in front of both inflation and output gaps and an expectations operator.

The classic example is that, starting at equilibrium, Fed officials estimate that the long-run nominal funds rate is 100 basis points higher than present. They could raise the funds rate by 100 basis points, but would risk upsetting markets by the abruptness of this move. Therefore, they might proceed more "gradually," perhaps in 25 basis points increments.

Now, if markets perceive this, they'll say, "Ah ha, not so fast, Fed, we know of your true intentions!" In other words, they'll perceive that the Fed *wants* to move 100 instead of 25, but isn't due to inertia. Therefore, they anticipate future movements and, per a given move in short-term rates, adjust long-term rates upward by a larger margin: in other words, the signaling effect of the short-term nominal interest rate is magnified.

The Fed as recent has communicated that the path will likely be gradually, though a few officials--Jim Bullard and Jeff Lacker, two of the biggest resident clowns--have indicated that we ought to take this with a "grain of salt" and that it depends on incoming data.

This is a *good* move, though for different reasons. We can attribute the flattening yield curve at present to perceptions of a slow rate path rooted in *fundamentals*, not in perceived policy inertia--i.e., if inertia were driving the path, long rates would be much, much higher today. That's why it's so dangerous when Yellen says that moving abruptly would "rattle financial markets." In reality, she should be focused on the forecasted path of the neutral real interest rate and the corresponding real effective funds rate necessary to generate the level of nominal GDP the Committee sees as consistent with its dual mandate.

So, in other words, the rate hike is already priced in. I think the Fed on Wednesday will signal, though not explicitly by putting it in the policy statement, a more "gradual" path than markets presently anticipate, which should have the effect of pushing equities up, long-term bond yields somewhat higher (unwinding long dollar positions), and the dollar down.

But we'll see. Again, if you don't think the Fed is lifting off, barring catastrophe, you're delusional.
~ResponsiblyIrresponsible

DDO's Economics Messiah
ironslippers
Posts: 513
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12/13/2015 12:03:11 AM
Posted: 12 months ago
Me I'm delusional
The US has yet to reach inflation targets
The ECB has reached into deeper negative interest rates -.3
Commodities are still tanking
New round of terrorist attacks

I want IR to be correct, So I can see his victory dance
btw glad to see you posting
Everyone stands on their own dung hill and speaks out about someone else's - Nathan Krusemark
Its easier to criticize and hate than it is to support and create - I Ron Slippers
ResponsiblyIrresponsible
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12/13/2015 12:27:54 AM
Posted: 12 months ago
At 12/13/2015 12:03:11 AM, ironslippers wrote:
Me I'm delusional

Okey dokey.

The US has yet to reach inflation targets

Indeed, though if you read into what FOMC participants--including Yellen, who represents the consensus--they believe that the bulk of the factors holding down inflation at the moment (relative energy and import prices) are transitory.

Look at Figure 8 of this speech by Yellen in September, for instance:

http://www.federalreserve.gov...

The overwhelmingly majority of that decline is a result of the dollar/energy prices. The Fed views that as transitory. The implication is that, once that wears off, they'll either be at or near their target. This has been a point emphasized not only by hawks like Mester/Bullard/Lacker, but it's even gained traction with Dudley/Fischer, who are effectively Yellen's "right hand men."

Not to mention, they're also of the view that they need to act *before* hitting their targets so that they (a) can move gradually and (b) can act ahead of the curve, because it takes about a year or two for the impacts of policy on employment/inflation.

Again, I'm calling you delusional not because you're making the very sensible point that continuously missing their inflation target might merit--or could reasonably merit--caution on the part of the Fed. That's a perfectly rational point and I would agree. But I'm arguing that, nevertheless, they *will* raise rates.

It's even a credibility thing: they've been basically screaming that they would raise -- and sometimes they coat it with "if economic conditions evolve as I forecasted!", but it's really a matter of how markets interpret it. Recently Fischer has been trying to coat it with "it's a forecast, not a commitment!", but the damage has already been done, especially when bellwethers like Lockhart say, for instance, ahead of September (before global financial markets tanked) that there was a "high bar for not moving." Insofar as they cling, even loosely, to date-based guidance, they tie their own hands.

The ECB has reached into deeper negative interest rates -.3

So? The dollar has been moving up for a long, long time--it's up about 17% on a trade-weighted basis from a year ago. They weren't focused on the dollar then, nor are they now. They view it largely as markets "pricing in" expected policy divergence, which will be with us for a while, and though it might temper the rate *path*, it won't temper the first move--and the operative point is that they are far, far (and they've emphasized this) more focused on the path than the initial timing. I think that misses the forest through the trees, but again I'm focusing only on what the Fed *will* do, not on what they ought to do.

Not to mention, they view this as a positive. We're likely to see even further easing by the ECB, and we've already seen further easing by the SNB, Swedish Riksbank, Denmark, etc., all of which are likewise experimenting with negative rates. Easier money--note that I'm not saying *easy* money--means faster global growth, so they discount the "transitory" impact on the dollar as outweighed by the somewhat faster trajectory of global growth. They view it as a net positive.

Commodities are still tanking

Of course they are--and this is the operative point. They'll revise down their inflation forecasts and maybe temper the path. But, again, they view this as transitory.

Jim Bullard, for instance, has argued that (a) that this *positive* supply shock ought to be a tailwind, as it bolsters consumption (though he won't tell you that (1) that never really panned out, (2) if it bears on inflation expectations, it can push down on consumption, (3) a lot of was saved, and (4) that it's crimping investment) and (b) that if we assume commodities don't move--i.e., stabilize at 0% growth--then we're at 2 percent inflation. The year-over-year inflation numbers will likewise stabilize a little in the year-on-year numbers just as a mechanical things, because in the early-to-mid part of last years there was *relative* stability in oil, before of course it tanked again (and now it's pretty much in freaking free fall).

New round of terrorist attacks

Only a few of them have even commented on these--and they were hawks, mind you (Mester and Lacker--I think Yellen might have as well, actually). They all pretty much said they're transitory disturbances that might impact financial markets and induce volatility, but that it's too transitory to impact their modal outlook. I would agree on this one. And, as my first post suggested, they want to look through volatility--and for good reason.

I want IR to be correct, So I can see his victory dance

Lol. I will be, don't worry.

btw glad to see you posting

Thanks!
~ResponsiblyIrresponsible

DDO's Economics Messiah
Chang29
Posts: 732
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12/13/2015 5:30:21 AM
Posted: 12 months ago
The effects of an anticipated series of rate hikes is already starting to be seen, example high yield bond fund liquidates http://www.nytimes.com...

Future casualties will be businesses that use short term financing for daily operations. Business models that have been profitable under artificially low interest rates will be exposed as Fed fueled mal-investments.

Will the Fed take responsibility for a recession caused by their actions? Rhetorical, everyone knows the answer.
A free market anti-capitalist

If it can be de-centralized, it will be de-centralized.
ResponsiblyIrresponsible
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12/13/2015 7:52:16 AM
Posted: 12 months ago
At 12/13/2015 5:30:21 AM, Chang29 wrote:
The effects of an anticipated series of rate hikes is already starting to be seen, example high yield bond fund liquidates http://www.nytimes.com...

I have a hard time buying the notion that this was caused by rate-hike expectations:

(a) if it was, it's probably just noise--there's always financial volatility surrounding FOMC meetings.
(b) It's been priced into markets for a pretty damn longed time. It was seen as a done deal since the release of the incredible October jobs report.
(c) Credit spreads have been gravitating upward since March.
(d) A lot of it is probable driven by the OPEC meeting: oil has been plummeting even more in recent days.

So, I don't buy it--but in all reality it's probably a function of liquidity issues, which would tend to make price movements appear more pronounced than they really are. High-yield bond finds are, likewise, not so systematically important so as to reflect the health of the broader economy.

Future casualties will be businesses that use short term financing for daily operations.

By a quarter point hike, even if long-term rates stay flat and/or decline (as is more likely)?

No, that's hogwash.

Business models that have been profitable under artificially low interest rates will be exposed as Fed fueled mal-investments.

Sigh. More of this "artificial sh1t."

As usual, you have no idea what you're talking about. Any interest rate is in a sense "artificial" because the Fed sets the monetary base--insofar as any country, ever, has a monetary authority set the base, they can likewise exert control over rates. Even a rate hike would be "artificial." The only objective metric is whether interest rates deviate from their "efficient" levels.

But, really, let me know if that's your argument--if so, you should be arguing that rates are *too high* at the moment.

Will the Fed take responsibility for a recession caused by their actions? Rhetorical, everyone knows the answer.

If you really think crashing junk bonds, most likely a correction from years of hoarding, is symptomatic of a broader recession, you're honestly delusional.

But, again, I've been arguing for ages that the Fed ought not lift off. That's just a really, really sh1tty indicator.
~ResponsiblyIrresponsible

DDO's Economics Messiah
Chang29
Posts: 732
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12/13/2015 3:10:22 PM
Posted: 12 months ago
At 12/13/2015 7:52:16 AM, ResponsiblyIrresponsible wrote:
At 12/13/2015 5:30:21 AM, Chang29 wrote:
The effects of an anticipated series of rate hikes is already starting to be seen, example high yield bond fund liquidates http://www.nytimes.com...

I have a hard time buying the notion that this was caused by rate-hike expectations:

(a) if it was, it's probably just noise--there's always financial volatility surrounding FOMC meetings.
(b) It's been priced into markets for a pretty damn longed time. It was seen as a done deal since the release of the incredible October jobs report.
(c) Credit spreads have been gravitating upward since March.
(d) A lot of it is probable driven by the OPEC meeting: oil has been plummeting even more in recent days.

So, I don't buy it--but in all reality it's probably a function of liquidity issues, which would tend to make price movements appear more pronounced than they really are. High-yield bond finds are, likewise, not so systematically important so as to reflect the health of the broader economy.

Future casualties will be businesses that use short term financing for daily operations.

By a quarter point hike, even if long-term rates stay flat and/or decline (as is more likely)?

No, that's hogwash.

You really do not understand effects of poor financing decisions on profits.


Business models that have been profitable under artificially low interest rates will be exposed as Fed fueled mal-investments.

Sigh. More of this "artificial sh1t."

It is what it is.


As usual, you have no idea what you're talking about. Any interest rate is in a sense "artificial" because the Fed sets the monetary base--insofar as any country, ever, has a monetary authority set the base, they can likewise exert control over rates. Even a rate hike would be "artificial." The only objective metric is whether interest rates deviate from their "efficient" levels.

But, really, let me know if that's your argument--if so, you should be arguing that rates are *too high* at the moment.

They are at an artificial level. A free market would never have rates this low for this long.


Will the Fed take responsibility for a recession caused by their actions? Rhetorical, everyone knows the answer.

If you really think crashing junk bonds, most likely a correction from years of hoarding, is symptomatic of a broader recession, you're honestly delusional.

But, again, I've been arguing for ages that the Fed ought not lift off. That's just a really, really sh1tty indicator.

I have never stated that the Fed ****ought**** not to "lift off". I have stated that the Fed will not raise rates due to poor economic conditions, which you agree that conditions do not justify a rate hike.

It is not a the first quarter point that is the problem, markets believe that once the Fed starts to raise rates in with continue at a steady pace. Yellen talks about the Fed being data dependent, to try to calm this fear. The problem with this talk is that data does not support the first hike, therefore why would data matter for future hikes.

With future rates being unknown, to most, people are not willing to invest in the junk bond market. There are many safer investments. Junk bonds, in many instances, are a barometer. When the pressure starts to drop, it is time to head for a sturdy structure, it might just be a little wind or a real storm.
A free market anti-capitalist

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ResponsiblyIrresponsible
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12/13/2015 3:20:35 PM
Posted: 12 months ago
At 12/13/2015 3:10:22 PM, Chang29 wrote:
You really do not understand effects of poor financing decisions on profits.

Nice try, but no.

This isn't a function of "poor financing decisions." Poor decisions are poor *irrespective* of whether or not the Fed moves rates up and down. The moving part is the Fed rate hike: unless you can prove that a measly, quarter-point rate hike will materially impact risk aversion such that it leads to a slew of poor financing decisions, you're, as usual, extremely confused.


Business models that have been profitable under artificially low interest rates will be exposed as Fed fueled mal-investments.

Sigh. More of this "artificial sh1t."

It is what it is.

No, it isn't--see my explanation below.


As usual, you have no idea what you're talking about. Any interest rate is in a sense "artificial" because the Fed sets the monetary base--insofar as any country, ever, has a monetary authority set the base, they can likewise exert control over rates. Even a rate hike would be "artificial." The only objective metric is whether interest rates deviate from their "efficient" levels.

But, really, let me know if that's your argument--if so, you should be arguing that rates are *too high* at the moment.

They are at an artificial level. A free market would never have rates this low for this long.

Not necessarily. I mean, if that free market abolished paper currency, rates would have been *negative* in nominal terms for some time, in which case they'd be higher today. That's because tight money in the past leads to low rates today. So, under a so-called free market, monetary policy would have been even *looser.*

Now, if nominal rates couldn't fall much below 0 or there were (plausibly) behavioral consequences to that happening, we'd get virtually the same outcome.


Will the Fed take responsibility for a recession caused by their actions? Rhetorical, everyone knows the answer.

If you really think crashing junk bonds, most likely a correction from years of hoarding, is symptomatic of a broader recession, you're honestly delusional.

But, again, I've been arguing for ages that the Fed ought not lift off. That's just a really, really sh1tty indicator.

I have never stated that the Fed ****ought**** not to "lift off".

I know: in that case, you would be wrong.

I have stated that the Fed will not raise rates due to poor economic conditions, which you agree that conditions do not justify a rate hike.

I agree that they don't justify a rate hike--though this is a horrid indicator, and one they will look to, particularly in light of the finding of Stein and Sunderam that I elucidated in my first post. I also explained at length in past posts--that you probably glanced over, and insofar as you actually read them, you didn't understand them--why the Fed *believes* that conditions merit a hike and the extent to which they're looking through the data that I would cite as most important.

Again, they will hike, whether you believe it or not.

It is not a the first quarter point that is the problem, markets believe that once the Fed starts to raise rates in with continue at a steady pace. Yellen talks about the Fed being data dependent, to try to calm this fear. The problem with this talk is that data does not support the first hike, therefore why would data matter for future hikes.

With future rates being unknown, to most, people are not willing to invest in the junk bond market.

This is probably true, on balance, but this will depend almost entirely on the extent to which the Fed clearly communicates the criteria for a subsequent hike, during for instance Yellen's press conference. If markets believe that the Fed will move at the pace of an injured snail, and their projections suggest as much, I can't see this being a problem. There hasn't been a problem with accepting that the path will likely be gradual: that's why the yield curve is flattening, for instance.

There are many safer investments. Junk bonds, in many instances, are a barometer. When the pressure starts to drop, it is time to head for a sturdy structure, it might just be a little wind or a real storm.

They're a really poor barometer, sans some other financial indicators suggesting a great deal of stress. That isn't the case, nor can you readily isolate this as part and parcel of fundamentals, as opposed to a correction for an anticipated rate hike.
~ResponsiblyIrresponsible

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ResponsiblyIrresponsible
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12/14/2015 2:02:28 PM
Posted: 12 months ago
Bumping this.

Any other nonsense about how "financial turmoil will stay the Fed's hand!"?

I mean, really, we could put money on it--or bragging rights. In fact, let me put my predictions on the record:

(a) The Fed raises the target range by 25 basis points.
(b) The language in the statement looks something like this:

"To support continued progress toward maximum employment and price stability, the Committee today decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. In consider subsequent increases, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates, based on its current assessment of the economic outlook, that it will be appropriate to raise the target range for the federal funds rate at a gradual pace."

(c) The dollar falls.

(d) They revise inflation forecasts downward.

(e) They revise RGDP forecasts upward.

(f) They revise employment forecasts upward.

*Both of the above point to slower productivity/trend growth, or at least convergence upon a lower trend line.

(g) They revise the expected path downward.

Anyone brave enough to match these?
~ResponsiblyIrresponsible

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ResponsiblyIrresponsible
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12/17/2015 1:52:59 AM
Posted: 11 months ago
So, I was right.

*claps*

But I was wrong on what actually mattered:

(a) forecasts for RGDP/employment/inflation were virtually unchanged.

(b) ZERO fcking dissents. I predicted two, which was already a deviation from the possible three, but we got fcking ZERO. Charlie Evans and Lael Brainard, you sell-outs are dead to me.

Okay, maybe not.. but, really, this "unity" bullsh1t is too little, too late, especially when both of you publicly testified *against* a rate hike just a few weeks ago.

(c) SEP forecasts virtually unchanged.

(d) I was right that estimates for long-run values weren't going to move, though the central tendency for the NAIRU was somewhat revised downward.

(e) Dollar was pretty much flat: stocks up, bonds down.

(f) Statement was more dovish than I expected--and *still* the dollar was flat. Markets were evidently pricing in a dovy statement. #mindblown

So, yeah, I'll concede defeat on a few of these things.

Oh, and this was the categorically wrong decision.
~ResponsiblyIrresponsible

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ironslippers
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12/17/2015 6:11:58 AM
Posted: 11 months ago
At 12/17/2015 1:52:59 AM, ResponsiblyIrresponsible wrote:
So, I was right.

*claps*

Sorry to have missed your celebratory gavotte
Could this be lift off, or will it fizzle out on the launch pad, perhaps a replay of the "Challenger". I doubt the latter. I'm just happy to see it get off the floor. The markets have had time to prepare since the last FOMC meeting and I will be looking forward to the next more hawkish round.
Everyone stands on their own dung hill and speaks out about someone else's - Nathan Krusemark
Its easier to criticize and hate than it is to support and create - I Ron Slippers
ResponsiblyIrresponsible
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12/17/2015 9:36:50 AM
Posted: 11 months ago
At 12/17/2015 6:11:58 AM, ironslippers wrote:
At 12/17/2015 1:52:59 AM, ResponsiblyIrresponsible wrote:
So, I was right.

*claps*

Sorry to have missed your celebratory gavotte

lol

Could this be lift off, or will it fizzle out on the launch pad, perhaps a replay of the "Challenger".

If history is any precedent, it's possible, though I highly doubt it as well.

I doubt the latter. I'm just happy to see it get off the floor. The markets have had time to prepare since the last FOMC meeting and I will be looking forward to the next more hawkish round.
~ResponsiblyIrresponsible

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