US Federal Reserve may still surprise markets with September rate move

Last week’s meeting of the US Federal Reserve concluded, as expected, with the Central Bank maintaining the key fed funds rate at 0.375% for a fourth consecutive meeting.

The decision to leave policy unchanged was unanimous, with all 10 of the voting members in agreement.

A few weeks back, the expectation had been building that the Fed could hike interest rates over the summer months.

However, some unexpected weakness in recent labour market data saw the Fed turn more cautious.

The meeting statement, while acknowledging this recent weakness in the jobs data, also emphasised the positives on the economy.

It noted that the “pace of improvement in the labour market has slowed” and that business investment “has been soft”.

However at the same time, the Fed also commentated that the “growth in economic activity appears to have picked up”.

It stated that consumer spending “has strengthened”, while the housing sector “has continued to improve” and the “drag from net exports appears to have diminished”.

The US economy grew by a weak annualised rate of 0.8% in the first quarter, following a sluggish 1.4% figure in the last quarter of 2015.

Some leading indicators of activity, though, have shown a modest pick-up in quarter two.

Meanwhile, consumer spending looks to have strengthened. Retail sales grew by 1.4% in nominal terms in the March/April period versus quarter one, in which sales declined by 0.1%.

Overall, growth in the economy appears to be regaining some momentum. Although, the Fed did slightly lower some of its economic forecasts from the March Federal Open Market Committee (FOMC) meeting.

The median GDP growth projection is now at 2% through 2018.

Low energy prices are providing some support to spending, while interest rates remain very low.

However, the economy does face some headwinds, such as a slowdown in emerging markets, financial market volatility, the impact from the stronger dollar and uncertainty over November’s elections.

Meanwhile, of more interest was the Fed’s latest set of projections on the likely path of interest rates, which now show a less aggressive pace of rate rises.

While the projections continue to indicate two rate hikes this year, the number of Fed voting members in favour of one rate hike in 2016 has increased from one to six.

Meantime, in terms of 2017 and 2018, the interest rate projections now indicate three rate hikes per year versus four per year in the March projections.

This would mean the Fed funds rate increasing to just 2.375% by the end of 2018, rather than 2.875% previously.

Despite the less aggressive path of interest rate hikes suggested by the Fed, the market continues to expect an even more gradual pace of rate increases.

Indeed, following the latest Fed meeting, futures contracts have pushed further out the timing of the next rate increase.

Prior to the meeting, the market was pricing in a 25bps increase around March 2017; however, this is now not fully priced in until September 2017.

Markets are pricing in just two rate increases by the end of 2018, taking the fed funds rate to just 0.875%.

In summary, the Fed retains its tightening bias, although the strength of this bias has weakened somewhat from its March meeting.

It continues to emphasise that the evolution of the economy will warrant only gradual increases in the federal funds rate.

The timing of the next interest rate increase will depend on incoming US economic data, especially on the labour market, as well as developments in the global economy and financial market conditions, including any fall-out if the UK votes this week to leave the EU.

If there is no material deterioration in global macro and market conditions and if the employment data over the summer months show improvement, then a rate increase could be on the cards in September.

This would be a major surprise for markets and could see the dollar strengthen in the second half of the year.

John Fahey is senior economist at AIB