head of a potential rate rise by the Fed in the coming weeks, Colin Cieszynski looks at the events that influence the decision and what impact it could have on the US economy.
Within this special report Colin Cieszynski focuses on:
• Current murmurings around a potential fed rate rise
• The impact the US presidential election and the Brexit vote have had on the Fed’s decision
• The potential outcome for the US economy in light of a Fed rate rise
Where are we now?
Coming out of the Fed’s Jackson Hole Conference, speculation has been growing that the Fed is considering raising interest rates in September. In recent weeks, two of the Big 3 Fed members, Fischer and Dudley, plus several regional Fed presidents including voters George and Mester, have indicated they think the US economy is strong enough to warrant another rate increase. Fed Chair Yellen in her speech to the conference indicated the US is approaching the Fed’s inflation and employment objectives keeping the door open to a rate hike this year but not committing to September or December.
What has been the impact of the US Presidential Election and post Brexit on a rate rise?
With the US Presidential election campaign underway it had seemed that the Fed would stay out of the way as usual and perhaps raise interest rates in December. Traders appear to be coming around to the idea of a September increase with Fed Funds having moved from a 0% chance at the end of June to recently pricing in a 36% chance of a September increase, having gone as high as 42% and then falling toward 28% following Friday’s nonfarm payrolls report Meanwhile, the market is still pricing into bonds a nearly 60% chance of at least one increase by December, including a 14% chance of two increases.
A September increase, should one arrive, should really be seen as an increase that should have happened in June which would have had the Fed on a gradual path of raising rates every six months. The June potential hike was delayed by the Fed wanting to see the results and impact of the UK Brexit vote.
Now that the dust from the EU referendum has settled and the markets appear to have weathered the initial storm, the Fed is starting to raise rates again. In fact, pressure on the Fed to make a move has been growing this summer as employment growth has rebounded, inflation pressures continue to rise and key indicators like retail sales and durable goods orders indicate a strong US economy.
New York Fed President Dudley recently reminded traders that at this point in the cycle, a rate hike should be seen as a vote of confidence in the US economy; meaning it is strong enough that central bank support is no longer required. Politically, an increase would seem to favour the Democrats who could spin this as evidence of their economic policies working. A delay to raising rates or a surprise cut could be spun by the Republicans as another sign the current system is broken in their view. That we are even talking about a Fed action at all indicates that the current race isn’t really that close and that a Fed decision either way would likely not be enough to tip the balance.
What about weaker than expected PMI and nonfarm payrolls reports?
The drive toward a September interest rate hike has run into headwinds in the last few days. First US ISM manufacturing PMI dropped into contraction territory, falling to 49.4 from 52.6 last month. Second nonfarm payrolls came in short of expectations at 151K below the 180K the street had expected.
While these indicators may give the Fed pause to reconsider September, a December rate hike remains clearly on the table. Markit PMI did not confirm the ISM decline, remaining near 52.0, Also, it’s important to remember Fed members have been lowering the threshold of job creation needed to raise rates with employment growth expected to slow as the country nears full employment. Fed members have indicated 50-100K as representing a steady job market and August remained above that. Also, even though the unemployment rate and hourly earnings growth were not quite as strong as expected, they remain below 5.0% and well above 2.0% respectively, indicating the job market remains robust.
What could the Fed decide to do?
At this point, I think there’s a 35% chance the Fed could still raise interest rates in September and a 65% chance the FOMC will use the September meeting to signal a rate increase is likely for December. To do this, Fed members could raise their economic forecasts, show it in the dot plot of interest rate projections or have a higher number of hawkish dissenters to the vote among regional presidents. Prior to the nonfarm payrolls report, I had been thinking the split was more 50-50 between the two options.
If the Fed does raise rates in September, there’s a 50-50 split between December and March for the subsequent rate increase. Dr. Fischer has indicated the potential for two rate increases this year, and discouraged thoughts of “one and done”, so the Fed also could go to a program of increases once every six months. Indications suggest a neutral rate of 1.00%-1.25%, so we may only see a program of 2-3 more increases unless inflation pressures really start to build.
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