Shifting Expectations from the Fed

With the fallout from Brexit largely contained, the Federal Reserve may present a less cautious outlook for the U.S. economy in this week’s FOMC meeting.

What risks concerned the Fed in June?

Brexit. Against a backdrop of slowing global growth, deteriorating central bank ammunition, and mounting political instability, the risks surrounding Britain’s June vote to leave the European Union forced the Fed to pause. Fearing both short-term financial market volatility and long-term economic uncertainty in the event of a “leave” vote, the Fed assumed a “wait and see” stance in its June meeting.

NFP bust. The Fed’s outlook in June was further complicated by an unexpected slowdown in the U.S. labor market. May’s abysmal non-farms payroll report (11,000) prompted the Bank to assess whether incoming data was an outlier or reflected a real deterioration in the outlook for the U.S. jobs market.

How have conditions changed?

Brexit better, but not resolved. Although the short-term financial market risks of the Brexit have been largely contained, long-term uncertainty is still high – both within the U.K. and across Europe. The economic impact going forward will hinge on the U.K.’s ability to negotiate comparable trade agreements and on the European Union’s ability to maintain cohesion during this transition. The Fed may take comfort in seeing the markets’ resilience in response to the shock; however, fundamental headwinds associated with the transition still remain.

Improving domestic data. Incoming data since last month’s NFP suggest the weak print may have largely been an outlier. This month, nonfarm payrolls surged to 287,000, well above market expectations. In addition, inflation data has continued to improve as the impact of low energy prices and the strong dollar roll off the calendar. Together, domestic inflation and labor market data suggest the economy is on track towards full employment and price stability.

What will the Fed do?

No hike, but more hawkish. Although domestic data continues to improve, the Fed will likely refrain from hiking in its meeting today for fear of shocking the markets, which have been buoyed by expectations for more central bank accommodation. The Fed will want to gradually shift these expectations by reintroducing the firm possibility of a hike in one of its next meetings. Because no press conference follows this meeting, much of this guidance is likely to follow in speeches and commentary in the coming weeks. As markets readjust, we expect heightened volatility in the dollar and equities.