United States: Fed holds its fire in September, policy debate intensifies

At its 21–22 monetary policy meeting, the Fed’s Open Market Committee (FOMC) announced its decision to leave the federal funds target rate unchanged at the current range of between 0.25% and 0.50%—a move in line with the Consensus, although a few analysts called for a rate hike. The Fed has been wavering about the prospects of a second rate move this year after heightened volatility in the financial markets following its December increase. Global headwinds have been the main case of delay, including uncertainties over the Chinese economy and economic policies, a sharp drop in commodities prices earlier this year and their subsequent rocky recovery, and the UK’s vote to leave the EU.

Also, the FOMC appears to be increasingly divided over the urgency of rising interest rates. This time, Kansas City Fed President Esther George, Cleveland Fed President Loretta Mester and Boston Fed President Eric Rosengren dissented on the policy statement, saying they favored raising rates this month. At the same time, the majority of U.S. monetary authorities cut the number of rate increases they expect this year from two to one, according to the average forecast released with the statement.

The FOMC said in its statement that, “the Committee judges that the case for an increase in the federal funds rate has strengthened, but decided, for the time being, to wait for further evidence of continued progress toward its objectives.” It added that risks to the outlook were “roughly balanced”, which is a further signal that a move could come at the end of the year. The market reaction to the Fed’s decision was muted. U.S. stocks climbed modestly and Treasuries were little changed, while the U.S. dollar maintained its relative strength. Following the decision, Fed Chair Janet Yellen commented at a press conference that the authority does not reckon that the economy is showing signs of overheating, but said that, “[it] has a little more room to run than might have previously been thought. That is good news.” Despite the hawkish tone of the message, some analysts do not think that the Fed will raise interest rates in November or even this year. Jan Hatzius, Chief Economist at Goldman Sachs, commented:

“Despite the hawkish statement, we see relatively low odds—now about 10%—of a rate increase at the November 1-2 FOMC meeting. There are a limited number of data releases before the November meeting, and even with strong data, officials would need to work hard to convince markets that the FOMC would hike just before the presidential election. […]. We are leaving our subjective odds of a rate increase this year at 65%, and now see odds of 10% for November and 55% for December. The committee looks inclined to hike soon, but a lot can happen between now and December, so a hike this year is not a done deal. Moreover, when faced with conflicting signals, a committee focused on risk management will be inclined to hold fire.”

Explaining his view that there will be no rate hike at all this year, Mikael Olai Milhøj, Senior Analyst at Danske Bank said:

“Although the more hawkish statement puts pressure on our Fed call, we stick to our view that the Fed will not hike this year, especially as we think the Fed may be too optimistic about the current economic situation given the weakness in ISM and retail sales, but it is a close call. However, incoming data will be analysed thoroughly in coming months and we may see markets react more to positive/negative data surprises.”

The U.S. monetary authorities did not give a clear hint of the timing of the next rate hike, but signaled that, “in determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to 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. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.”

The U.S. Federal Reserve cut its interest rate median projection forecast for this year and expects it to average 0.6% (previous estimate: 0.9%), which is line with the Consensus view of our panelists. The panel sees the federal funds rate averaging 0.62% at the end of 2016. For next year, the Fed trimmed its interest rate projection, which is now more in line with our panelists’ forecasts. The Fed projects, on average, that the federal funds rate will end 2017 at 1.1% (previous estimate: 1.6%). The Consensus view among analysts is that the Fed funds rate will end 2017 at 1.13%.