Fed holds open prospect of 2016 rate rise

Posted on July 27, 2016

Janet Yellen, chair of the U.S. Federal Reserve, waits to testify during a Senate Banking Committee hearing in Washington, D.C., U.S., on Tuesday, June 21, 2016. Yellen offered a subtle change to her outlook from less than a week ago, saying she and her colleagues were on watch for whether, rather than when, the U.S. economy would show clear signs of improvement. Photographer: Pete Marovich/Bloomberg©Bloomberg

The Federal Reserve held open the prospect of a second increase in interest rates later this year as it said that near-term risks to the US economy had diminished and the job market recovery had regained momentum.

The Federal Open Market Committee kept the target range for the federal funds rate at 0.25 per cent to 0.5 per cent at the end of its latest two-day meeting, leaving the rate where it has been since the Fed lifted it by a quarter point from near-zero levels in December.

    The US central bank signalled that some of the immediate worries that hung over its meeting in June have since abated, notably the prospect of a severe blow to global markets stemming from the UK’s referendum on European Union membership.

    The Fed has three scheduled meetings left this year in which it could move rates — in September, November and December — and its words leave open the chance that it could act as soon as September. Complicating its deliberations are the highly uncertain prospects for the US presidential election in November, which could weigh on business or investor confidence.

    While it did not explicitly refer to the Brexit vote, the committee said: “Near-term risks to the economic outlook have diminished.”

    However the Fed also maintained that it remained on guard for renewed turbulence in markets or world economies, suggesting that it would continue to tread carefully before considering a second rate rise. “The committee continues to closely monitor inflation indicators and global economic and financial developments,” it said in a statement.

    After initial jitters on the mention of receding economic risks, the US government bond market shrugged off speculation that the Fed could tighten rates as early as September. The 10-year Treasury extended its rally, pushing the yield 4 basis points lower on the day to 1.52 per cent, while the two-year Treasury bond — the most sensitive to interest rate movements — dipped 2bp to 0.73 per cent, after initially spiking higher when the Fed statement was released.

    The US dollar also gave up early gains, with the DXY dollar index sliding 0.4 per cent, and the S&P 500 stock market index rising to trade modestly positive.

    The remarks about receding economic risks lifted the US dollar and reversed an earlier rally in short-term Treasury bonds. But longer dated US government bonds held on to their gains, with the 10-year Treasury yield trading at 1.52 per cent after some initial jitters, close to where it was ahead of the statement, while the S&P 500 gained to trade flat on the day.

    “Markets had been slowly pricing in a higher likelihood of a rate hike by the year-end and have returned to pre-Brexit expectations in recent days,” said Rob Carnell, chief international economist at ING. “But judging by the text of the accompanying statement to the Fed decision, it looks as if they are trying to prepare markets for a hike far sooner than markets have been expecting.”

    The Fed last month pared back its interest-rate forecasts as it assessed foreign hazards including the prospect of a UK vote to leave the European Union, as well as subdued US jobs numbers. Since then, markets have rebounded, reducing some of the concerns about the knock-on effects of the Brexit vote outside Europe.

    The International Monetary Fund this month trimmed its world growth forecasts because the Brexit vote has caused a “substantial” increase in economic, political and institutional uncertainty. However the Fund left its forecast for US growth next year unchanged at 2.5 per cent while paring its 2016 outlook.

    A sharp slowdown in payroll growth heavily influenced the Fed’s June meeting, but since then there has been a bounceback in hiring, with payrolls growing by 287,000 in June, at least 100,000 more than had been forecast by analysts.

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    epa05214728 A Federal Reserve security agent prior to Chair of the US Federal Reserve Janet Yellen's press conference at the Federal Reserve in Washington, DC, USA, 16 March 2016. The presss conference comes at the conclusion of a two-day meeting of the Federal Open Market Committee (FOMC), led by Fed Chair Yellen. EPA/SHAWN THEW

    Parsing the Fed meeting statements

    In its statement on Wednesday, the Fed described job gains as “strong” in June following the weak growth in May, and added that there had been some increase in the utilisation of labour market resources. It also highlighted strong growth in household spending, the key driver of the US economic recovery. Overall activity growth remained “moderate”, the Fed added.

    The New York Fed has published so-called now-cast estimates suggesting that GDP growth in the third quarter should accelerate to a respectable 2.6 per cent annualised pace from 2.2 per cent in the second quarter.

    Esther George, the hawkish president of the Kansas City Fed, renewed her call for an immediate rate increase, but the rest of the FOMC voted for rates to remain unchanged.

    With inflation expectations still relatively subdued, a number of other Fed policymakers have suggested that they want to see clearer signs that inflation is heading towards target before lifting rates again. Core inflation measured by the personal consumption expenditures price index is at 1.6 per cent, which remains some way below the Fed’s 2 per cent goal.

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    The Fed’s statement noted that inflation compensation measures were still “low”, while survey-based measures of inflation expectations remained little changed.

    The statement reiterated the Fed’s longstanding guidance that rate increases will be gradual.

    A host of economic indicators will emerge before the Fed meets again in September, including two more employment reports and second-quarter gross domestic product numbers.

    With financial markets regaining much of their pre-Brexit poise and US equities hitting record highs, investors have been pricing in a higher chance of a second US rate increase before the year is out.

    Before the Wednesday rate announcement, traders were putting the chances of a move in September at about one in four, according to CME Group. That is a marked contrast to the situation in late June, when investors were starting to discuss the potential for the next Fed move to be a rate cut.

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