FOMC Watch - FOMC leaves door for September hike wide open

Dissents aside, the FOMC statement was identical to the one released in June and as was the case with the previous edition, it provided little colour on the Fed’s reaction function going forward. The only take away, is that the FOMC remains more concerned about the inflation side of its dual mandate, rather than the full employment part. It noted that ‘job gains have kept pace with the workforce, and the unemployment rate has changed little’ but that ‘inflation remains elevated relative to the Committee's 2 percent goal’. Against this background, it stressed its commitment to ‘deliver price stability’.

This theme was picked up strongly by new Fed Chair Kevin Warsh in the press conference, where he gave a few more indications of the central bank’s reaction function. Mr Warsh noted that inflation had been above target for five years and this may have led some households and businesses to take the view that the central bank was comfortable with the situation of above-target inflation. In other words, they may have taken the view that above-target inflation was the Fed’s ‘revealed preference’. He stressed that the Fed did not have ‘a soft target’, it had a hard 2% target and the Fed would ‘not waiver’ in taking the right actions to achieve it. Part of this ‘hawkish’ communication might be designed to directly anchor inflation expectations, which the Fed Chair noted would partly also determine the inflation outlook.

However, these statements seem to be more than just tough talk just to anchor inflation expectations. Mr Warsh noted that in a situation where the central bank was meeting the labour market side of its mandate and underlying inflation was high and rising, any central banker would be more inclined to be raising interest rates. In addition, he stressed there was no trade-off between the two sides of its mandate, as meeting the inflation goal was a pre-condition to sustaining full employment.

Finally, the Fed Chair stressed that financial markets themselves were an important source of information and the FOMC’s retreat from forward guidance could allow this signal to be ‘direct and unfiltered’. Against this background, he noted that both nominal and real yields had risen since the last meeting in response to economic data, which had shown ‘impressive resilience’. It seems that the FOMC is taking the market signal to be – at least on the basis of recent data – that policy rates should eventually go higher. At the same time, higher rates were doing the Fed’s tightening job for it, which could be interpreted as making actual hikes less necessary.

Overall, the Fed clearly left the door for an interest rate hike in September wide open. However, a lot will depend on the data between now and then. Our base case sees the Fed keeping interest rates on hold in the coming months because (1) we expect the Strait of Hormuz to re-open and oil prices and hence inflationary pressures to come down (2) we see inflation as being more supply-side than demand-side driven with few signs of second round effects so far (3) we expect to see some softening in the labour market given that we judge that a number of transitory factors have been boosting nonfarm payrolls recently. Having said all this, the risks of a policy rate hikes remain significant, and actually would be very likely if energy prices were to remain close to recent highs.