United States Monetary Policy May 2016

United States

United States: Minutes of April meeting open the door to June rate hike, but skepticism persists

May 27, 2016

At its 26–27 April monetary policy meeting, the Fed’s Open Market Committee (FOMC) refrained from making any changes to its policy and did modify its messaging, which has been interpreted by analysts and market participants as modestly hawkish about the possibility of a rate hike in the upcoming meeting on 14-15 June. Yet the minutes of the FOMC meeting in April that were released on 18 May delivered a major hawkish surprise to the markets. The minutes reported that “most participants” thought that a rate hike would be more appropriate in June if growth picks up, the labor market continues to strengthen and inflation rises. While some analysts remain skeptical that the next hike will come as early as June, the minutes significantly raised the odds of a rate raise and reaffirmed that monetary policy is still on a normalization path. Chief Economist Jan Hatzius and Senior Economist Zach Pandl at Goldman Sachs commented:

“The minutes from the April 26-27 FOMC meeting delivered a major hawkish surprise. While markets viewed the odds of a June rate increase as very low before the release, the minutes reported that ‘most participants’ thought a hike would be appropriate in June ‘if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective.’ With the economy broadly on track to meet these targets, we see this new information as meaningfully raising the odds of a June hike. Nevertheless, we continue to see the odds of a June hike as below 50% for two reasons. First, we interpret recent commentary from Fed officials as implying that the uncertainty surrounding the Brexit vote—a concern also raised in the minutes—makes a hike at the June FOMC meeting the week before less likely. Second, the very low market-implied probability of a hike just a month prior to the meeting would make a June hike a unique outcome in modern Fed history.”

Several Fed presidents had commented that markets were underpricing the possibility of an increase in June, since they were placing more emphasis on the weak Q1 GDP figure. Moreover, the hawkishness was further underlined by comments from New York Fed President Bill Dudley—a particularly influential member of the FOMC, closely aligned with Chair Janet Yellen—who said that a rate hike in June or July was a “reasonable expectation”. Following these comments and since several economic indicators have improved from the first-quarter lull, the market probability of a June interest-rate hike rose to 30% and that of a July increase rose to 51%, according to data compiled by Bloomberg. However, some analysts still believe that these developments are not enough. Thomas Costberg, Senior U.S. Economist at Standard Chartered, said:

“This hawkishness challenges our call that the Fed will abstain from hiking rates over the summer, but for now it is not sufficient for us to change tack. We see this hawkish resurgence as (1) some irritation from Fed members after market expectations for a summer rate hike plummeted before the minutes and (2) a ‘trial balloon’ to gauge market reaction to potential Fed hawkishness, especially regarding the USD and risk assets. To change our view, we would need to see more hawkish comments from Chair Yellen as well as a notable improvement in the data.”

Politics are muddying the water of the Fed’s decision-making in 2016. The next FOMC meeting will take place on 14–15 June, which is just a week before the UK votes on whether to stay in the European Union. The polls regarding a “Brexit” are too close to call and it could be risky to increase U.S. interest rates one week before a UK referendum that has substantial consequences for the global economy. Regarding the UK referendum, Mikael Olai Milhøj, Senior Analyst at Danske Bank says:

“Our main scenario is still that the Fed will wait with hiking until the FOMC meeting in September and only hike once this year among other things due to our judgement that most voting FOMC members are dovish. By waiting until September the Fed has more time to judge incoming data and we will also be past the UK’S EU referendum. With respect to the latter the minutes state that ‘some participants noted’ that markets are sensitive to the upcoming referendum. That being said, the probability of a hike in either June or July has definitely increased on the back of the FOMC minutes and the door for June was never completely shut although we thought so – even despite the somewhat weak employment growth in April.”

Should the Fed think that domestic economic conditions are sufficient to warrant a rate hike in June, a six-week delay to allow for the “Brexit” vote to be resolved looks like a more prudent approach. For the U.S. economy, the ripple effects from the UK voting to leave the EU are likely to be small. However, they will not be negligible, especially for global financial markets. The risk of a “Brexit” may convince Fed Chair Yellen to delay the next increase to September, while domestically political events will also factor into her thinking later this year as uncertainty grows ahead of the U.S. presidential election in November, which will make an interest-rate move at the meeting 1–2 November tough.

While the Consensus among analysts is for an interest-rate increase in Q2, some economists remain cautious. On average, the Federal Funds Rate is expected to end Q2 at 0.60%. Going forward, analysts expect the Fed to continue tightening the interest rate. The panel sees the Federal Rate averaging 0.91% at the end of 2016 and projects that it will increase to 1.74% by the end of 2017.

Author:, Senior Economist

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USA Monetary Policy May 2016 2

Note: Total assets on the balance sheet of the Federal Reserve in USD billion and Federal Funds Target Rate in %. Current rate set at a range of between 0.25% and 0.50%.
Source: Federal Reserve

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