Why Is The Fed Keeping The Door Open To Higher Rates?

by: Lior Cohen

Summary

The Federal Reserve didn't raise rates in June.

The Fed reduced its outlook for the cash rates in 2017 and onward but left the door open to two hikes this year.

Will the Fed raise rates anytime soon? Why is the Fed keeping the door open for more hikes?

The FOMC decided, as expected, not to raise rates in the recent June meeting but in the press conference that followed the release of the statement, Chair of the FOMC Janet Yellen left the door open for a rate hike as early as July if market conditions - mainly the labor market - improve. But is the Fed actually considering raising rates anytime soon? And if not, why is the Fed leaving the door open?

First, let's take a look at the recent revised dot plot chart, which shows the FOMC reduced the median outlook for the cash rate in the coming years, as indicated in the following table.

Source: Federal Reserve

For 2017, the median cash rate was reduced by 0.25 basis points, and for 2018, the rate was cut by 0.5 basis point. Despite these downward revisions, the Fed still left the median cash rate at 0.875% for 2016, which implies two rate hikes this year. Also, Chair Yellen reiterated that the decision to raise rates remains data dependent (no surprise here).

Even though the Fed didn't change the median cash rate for 2016, the composition of the FOMC members has changed.

Source: Federal Reserve

If back in March 2016, only one member thought of a single rate hike this year, this time 6 members thought so. But the majority of the members still think of two rate hikes by the end of 2016. In the bonds market, however, the implied probability of a rate hike this year is only at 41%. This could be one of the reasons Chair Yellen is trying to convince the market that a rate hike is possible in July. The market is more dovish than the FOMC; and while the dot plot doesn't coincide with what the Fed eventually implements, it still is where the Fed wants the market to be. But given the current market conditions, the uncertainty of the global economy, the growing - albeit not high - possibility of a recession in the U.S., the deflationary pressures in the developed economies and the uncertainty around the political scene in the U.S., the Fed will do poorly to raise rates in the coming months. One of the reasons for the FOMC to keep pushing for higher rates could be related to the Federal Reserve System, in which regional banks presidents also vote in the committee; this system as stated by the Economist puts more pressure on Yellen to raise rates, because regional banks presidents tend to be more hawkish as they closely work with commercial banks; and the latter prefer to see higher rates that could improve their profits. For now, the FOMC didn't change the outlook for 2016 but did so for the following year.

In conclusion…

Even if the last non-farm payroll report was a "one-off" and the next report shows a gain of over 200,000 jobs, the Fed will be less inclined to raise rates next month. For now, it seems very unlikely and more a matter of pushing the market towards where the FOMC currently stands - i.e. looking towards two rate hikes this year. Market conditions remain unfavorable and the risk of higher inflation seems much smaller than the risk of another recession. If the Fed does raise rates in the coming months, it could be deemed as a poor decision equal to the one made by former ECB president Jean-Claude Trichet back in July 2011 in the midst of Greek debt crisis and economic turmoil in the EU.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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