US Fed likely to keep cautious policy stance; but risk skewed towards more hawkish Fed

The FOMC (Federal Open Market Commitee), at its upcoming meeting on Wednesday, is likely to keep the federal funds target on hold. According to a Danske Bank research note, the FOMC will keep the federal funds target range unchanged at 0.25 percent – 0.5 percent. The focus is likely to be on the statement, noted Danske Bank.

Even if the effects of Brexit on financial markets have been negligible and the US equity market is at an all-time high, the FOMC is likely to take a cautious stance because of likely negative spill-over effects from uncertainties surrounding Brexit, according to Danske Bank.

However, risk is still skewed towards a more hawkish Fed with the solid recovery in the US data for the second quarter, particularly on the consumer side. Fed is expected to remain wary due to Brexit. FOMC, in its previous meeting’s minutes, had mentioned that the US Fed would have to ‘wait for additional […] information that would allow them to assess the consequences of the U.K. vote for global financial conditions and the U.S. economic outlook’.

Only a few data have been released after the Brexit vote. Thus it is quite soon for the US central bank to come to a conclusion about anything and it would require additional data to assess the Brexit’s effects on the US economy.

Even if certain data releases following the Brexit vote have been encouraging, the Michigan consumer sentiment index had dropped in July because of Brexit. Therefore, the Fed is likely to reiterate that it will continue to keep a close watch on inflation indicators and global and economic and financial developments with Brexit as one of the largest threat to the economic outlook, noted Danske Bank.

During the previous FOMC meeting, most of the talk was about the present scenario in the labor market because of subdued job reports in April and May. Therefore, the US Fed is likely to welcome the recovery seen in employment in June. Given that the ISM indices have recovered and retail sales in June were solid, the US Fed is expected to reiterate that the economic growth has rebounded in the second quarter following the slowdown witnessed in the first quarter. It might also note that the growth was robust.

The solid activity indicators in the second quarter and the recovery in employment growth in June signify that risk is skewed towards a more hawkish Fed in spite of Brexit, stated Danske Bank.

“We still expect the Fed to be on hold until June 2017 and only hike twice next year (following hike in December 2017). Markets’ pricing is even softer as they have priced in just two-third of a hike this year and a total of 1.25 hikes by year-end next year (approximately)”, added Danske Bank.

But if the US economy continues to expand steadily and the labor market continues to rebound in spite of Brexit, the hiking theme of the US Fed might become real again. Certain recovery seen in financial markets since the Brexit vote is predominantly because of expectations of additional dovish central banks. Thus if the US Fed starts talking about rate hikes again, markets might respond negatively that might ultimately result in  the US Fed delaying the hike again, said Danske Bank.