Without the Brexit vote in the UK, there would have been a very strong case to be made for a September rate hike by the Fed. Indeed, one could argue that there still is. But with central banks elsewhere in the world in damage limitation mode and eyeing further easing, it is certainly plausible for the Fed to take stock of the situation a little longer. Market expectations for the timing of the next Fed rate hike have eased forward recently, helped by strong US data, including labour market data, but also a Wall Street Journal article suggesting the Fed may still be eyeing a September hike. But expectations for the next hike are still lodged at the back-end of next year.
Partly as a result of limited Fed hike expectations, risk appetite remains good. If this Fed expectation turns out to be mistaken, then risk sentiment could sour quickly, making it far harder for the Fed to hike. If this sounds like circular reasoning, it should do. It is. There are some lurking political problems that may serve to keep the Fed on hold for longer, namely a reform referendum in Italy and elections in France and the Netherlands. An upset in any of these votes could also provide further excuses for Fed inaction, but would also seriously upset market sentiment too. But despite all this, the domestic US economy is still looking in relatively good shape.
Models from the New York Fed suggest 3Q16 GDP is shaping up at about 2.5%. Financial conditions too – though prone to change at a moment’s notice – are looser in the US post-Brexit, with the decline in bond yields more than outweighing any upshift in the trade weighted dollar. So given this favourable backdrop, and bearing in mind the political caveats we mentioned earlier, we expect the Fed to start guiding the market towards a more imminent rate hike in the statement released on 27 July, and through speeches in the following weeks and months.
With limited room for manoeuvre in the statement, the most we can hope for is an upgraded activity and labour market assessment in paragraph 1 of the statement, along with an acknowledgement of the improvement in inflation expectations in the same paragraph. But paragraph 4 might re-introduce some text along the lines followed in October 2015, when the Fed talked about the “balance of risks” to inflation and growth being “nearly balanced”, though they might temper this with some reference to uncertainties in the international environment to give themselves a little wiggle-room. The difficulty for the Fed will be trying to encourage the market to price in something a little more hawkish than they are currently doing, without causing risk sentiment to evaporate. This is a tricky balancing act. As long as the data continues to run well in the US, this should be possible. But it is a risky business. We continue to forecast the next hike in 1Q17.