Fed Strikes More Hawkish Tone as Near-Term Risks Fade

It wasn’t quite an October-like promise that would pave the way for rate hikes at the next meeting, but the Federal Reserve on Wednesday struck a more hawkish tone, indicating it could be ready to raise short-term interest rates sooner rather than later.

In a statement following its two-day monetary policy meeting, the central bank said it saw improvement in the health and strength of the U.S. economy as near-term risks to the outlook diminished and the labor market showed signs of strength in June after an unexpectedly weak non-farm payrolls report in May. Still, the Fed wasn’t quite ready to lift rates, and said it would continue to keep a close eye on domestic inflation picture and any development in the global economy and financial markets.

“This is what we expected,” Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management, said. “The Fed didn’t give any information about what it would do in September, which is reasonable because in August we have the Jackson Hole meeting and they’ll probably give a better idea [about future changes in policy] at that time.”

Wall Street was left to digest the Fed’s latest decision without the color of a scheduled press conference by Chief Janet Yellen. U.S. equities traded along the flat line in late-afternoon action, while the yield, which moves inversely to price, on the benchmark 10-year U.S. Treasury bond dipped to 1.515%.

Meanwhile, expectations for future rate hikes as measured by fed funds futures dipped following the July meeting. September rate-rise odds slipped from 26.8% to 18%, while odds for a hike by the end of the year dipped to 46.5% from 52.2%.

Ren said central bankers are most concerned about global developments, particularly in Europe and Asia, and reluctant to raise rates until they have a better understanding of economic conditions there. On top of that is last month’s Brexit vote, which sent global markets into a temporary panic and is likely to push the U.K. into recession in the coming months.

“My base case scenario is the Fed will wait a few more months to see how Brexit will affect the economy,” he said. “The reason not to hike is we don’t know how Brexit would lead to weaker overseas economies, what China or the Bank of Japan will do, if they will do anything more in the currency market. All of these unknowns prevent the Fed from making a decision.”

But Bankrate chief financial analyst Greg McBride said the U.S. central bank can’t be in wait-and-see mode forever.

“At some point, the Federal Reserve has to be willing to raise interest rates under a less-than-perfect set of conditions. If they’re waiting for world peace and harmony before raising interest rates again, they’ll never do it,” he warned.

The good news: The Fed clearly sees improvements in the U.S. – and if it were to base its decision solely on the health of its own economy, Ren estimates it would likely have already been confident to move rates higher. He pointed to strength in both the labor and housing markets, improving retail sales and consumer spending figures, more upside surprises in recent economic data than downside, and fairly strong second-quarter earnings results.

“The current problem is there are too many headwinds from overseas,” he said. “You have the domestic economy doing well, the global economy not so well, which is preventing the Fed from moving…another reason they can afford to be patient is because there is no inflation pressure in the system.”

He said should more inflation come into the economy, the Fed’s long pause option would be eliminated and it would need to take swifter action to move rates up or risk the unintended consequences of an overheating economy.