Fed Regains Course

The Fed revisits a rate hike in 2016, pressuring its peers to act on market expectations.

What did the Fed do?

Balanced, but hawkish. In its June statement, the Fed emphasized the impending Brexit referendum as a key risk to its outlook. Coupled with a lackluster employment print, this dovish communication sent expectations for a 2016 rate hike to near zero. Since then, political stabilization in the U.K. and stronger U.S. data have tempered fears about global market volatility. Against this backdrop, investors see an over 50% chance that the Fed aises rates by the end of this year, and the Bank appeared more hawkish in July.

What are the implications?

Hike in 2016. Throughout the course of this year, the Fed has purported that it will raise rates at least once this year; one FOMC member, Esther George, has consistently voted for a rate hike. After a unanimous decision to maintain policy in June, George voted to increase rates once again in July. Unless there is a dramatic geopolitical risk this year, the Fed is likely to maintain its intended course for 2016.

Fragile risk rally. After an immediate plunge, global equities rebounded post-Brexit. If the Fed moves forward with rate normalization, it will remove itself as a driver of this rally. In this light, it will be harder for market expectations to sustain equity upswings. Furthermore, U.S. data are not entirely strong: the outlook for U.S. businesses remains subdued, with business fixed investment soft and earnings in the second quarter contracting from last year.

What does it mean for global policy?

Pressure for easing. In some ways, U.S. rate normalization is desirable for global monetary policy. Unless U.S. rate hikes dramatically shake market sentiment, Fed rate normalization is likely to draw currency flows to the dollar, relieving pressure on several safe-haven destinations to depreciate their currencies. However, with the current market rally now hinging on market anticipation for policy easing in Japan and the Eurozone, there is more focus on these central banks to deliver on expectations. If the BoJ and ECB fall short of expectations, a dramatic market fallout is more likely to ensue.