Global risks make September rate liftoff "less compelling"

This week’s events served as a reminder of how quickly sentiment can turn. While wild market gyrations made headlines every day, the mood became more upbeat in the latter part of the week. Investors took comfort in comments by N.Y. Fed president Dudley regarding the timing of the rate liftoff, as well as a slew of positive U.S. economic data.

The week started off with another rout in Chinese equity markets, which pulled the Shanghai Composite down by 8.5% on Monday. Mounting concerns about the health of Chinese economy and its implications on global growth weighed heavily on investors’ sentiment, with the selloff spreading to global markets, with both equities and commodities tumbling. Following another disappointing trading session on Tuesday, the PBOC moved in with a slew of fresh monetary stimulus measures, cutting by 25 bps the benchmark lending and savings rates and trimming the banks’ reserve requirement ratio by 50bps. These new measures brought modest respite to the struggling mainland markets, which remain some 40% off their June peaks, and should help lift China’s economic growth slightly over the near term. The recent turmoil in global financial markets has certainly not gone unnoticed by the Fed. On Wednesday, Dudley sounded a note of caution, saying that the decision for a rate hike at the upcoming FOMC meeting in September “seems less compelling than it was several weeks ago”. While he did not completely shut the door on a September lift-off, the likelihood of this happening appears significantly diminished, with markets re-pricing the probability of this event from better-than-even two weeks ago to mid-30% this morning.

The Fed’s hesitation to begin rate liftoff in September is not motivated by the recent U.S. economic performance. In fact, economic momentum has been quite buoyant, and this view was further cemented with this week’s data. According to the second estimate, real GDP advanced by 3.7% (annualized) in the Q2 of 2015 – considerably stronger than the 2.3% gain reported in the advance estimate and well-ahead of the market expectations for a 3.2% increase. Some of the strength seen in the second quarter numbers was effectively borrowed from the first quarter, which was hindered by transitory factors. Still, in spite of the lackluster first quarter print, growth in the first half of the year has averaged 2.2% – a respectable performance considering the headwinds stemming from a surging dollar and severe cuts to energy-related investment. More timely data also point to an encouraging start of the third quarter. This week, data released on new home sales, durable goods orders and personal income & spending for July remained robust, suggesting the positive U.S. economic momentum should persist.

While the recent performance in the real economy may augur for a September rate lift-off, the same cannot be said of inflation. Inflationary pressures remain weak as significant appreciation of the U.S. dollar, pass-through from low commodity prices and the still-tepid wage dynamics weigh on both headline and core measures. The core PCE inflation – the Fed’s preferred measure of price growth – has been stuck near 1.3% over much of this year and drifted lower to 1.2% in July. We expect core PCE inflation to remain pressured by lagged effects of dollar and commodity moves. But, these effects have already been “baked in”, and the soft print on core PCE should not be a hindering factor for near-term Fed hikes. However, recent international developments may pose additional downside risks to inflation, and thus expect the Fed to sit tight in September.

"The bottom line is that the U.S. economy remains on solid footing. However, uncertainty related to global growth prospects poses a clear downside risk to inflation. The Fed appears cognizant of that with the case for a September liftoff weaker as a result. Nonetheless, we don’t believe the Fed will overreact to short-term developments, with Dudley himself unsure whether the recent moves are a “temporary adjustment or something more persistent.” The Fed has long telegraphed its desire to raise rates this year, and unless the global macro backdrop deteriorates substantially, we expect the Fed will make good on that pledge," noted TD Economics.