FOMC preview: Hold expected, as outlook remains cloudy

The Federal Reserve is expected to remain on hold when it announces its decision later on Wednesday.

While a hold in rates at 3.5- 3.75% is likely, rising oil prices means that futures markets have priced in a growing chance of a rate hike at this meeting. The CME’s FedWatch tool indicates that there is a 30% chance of a rate hike at tonight’s meeting.

The question is, will  new chair Kevin Warsh spring a ‘surprise’ hike on financial markets? The Fed Fund Futures market thinks that there is a decent chance that the Fed will embark on a preemptive rate hike to address potential inflation risks ahead of time. But is the market right to think  this?

If the Fed does decide to hike rates tonight, then it would not be grounded in the current labour market or inflation readings, instead it will be rooted in risk management, in case this changes in the future. The current economic data available to the Fed does not suggest that the US economy is overheating. June NFPs slowed substantially to 57,000, and the May figure was also revised lower to 129k. The unemployment rate held steady at 4.2%, but there was a sharp drop in the labour force participation rate, which fell to 61.5% from 61.8%.

The inflation outlook has also moderated in recent weeks. Headline inflation fell 0.4% on a month-on-month basis in June, and the annual rate was 3.5%. Core CPI was flat on a monthly basis, but the annual core CPI rate moderated to 2.6% from 2.9%. There are also signs that inflation could moderate further in the coming months:

• Tariff pass-through has been less than expected and should fall out of the CPI index in the second half of this year.
• Shelter inflation has also moderated sharply, which is a sign that super core inflation is coming back under control.
• Falling energy prices could lead to greater disinflationary forces on the CPI rate later this year.      

There are still some outstanding concerns regarding price pressures, for example, the rising costs of AI and business investment, and the ongoing tensions in the Middle East, which is causing volatility in the oil price. However, we think that a preemptive rate hike at this stage would be premature, since the Fed cannot control geopolitical risks that trigger energy price rises.

The problems with ending forward guidance

Governor Warsh has spoken about the variety of views at the Fed, and we expect these to be on show tonight. If the Fed remains on hold, as we expect, then traditionally the market would have expected some sort of timeline to understand how long the Fed is willing to either see through energy price spikes, or when disinflation will be enough to allow for rate cuts. The problem is that Governor Warsh is no fan of forward guidance, and we do not think that he will lay out a timeline for policy change at tonight’s press conference. These increase the chance of investor confusion in the aftermath of tonight’s decision, which is one of the main risks to abandoning forward guidance.

The market impact

In the absence of forward guidance, the impact on financial markets from tonight’s decision is binary. We think that the markets are overstating the chances of an immediate rate hike, and therefore any decision to remain on hold, even if there are hawkish dissents, could be seen as dovish. This could weigh on  Treasury yields and the dollar. The USD index is higher by 3% so far this year and is at its highest level for more than a year, we think GBP/USD could be a beneficiary if the Fed does remain on hold this evening.

The dollar has held a firm defensive position against the pound for the last 6 months, as GBP/USD has fallen back from a high above $1.38, it is currently trading around $1.33. In recent weeks, GBP has been pressured by haven demand for the dollar on the back of rising tensions in the Middle East. GBP/USD has also been negatively impacted by differing expectations for the path of central bank policy. Leading up to the Fed meeting, the Fed Fund Futures market is pricing in a 33% chance of a rate hike, however, there is only a 2% chance that the BOE will hike rates this week. This differential has dampened demand for GBP/USD.

However, if the Fed holds rates tonight, as we expect, then GBP could bounce back. Key near-term resistance lies at $1.3428, the 200-day sma, a move above this level would signal a bullish shift in direction for this pair.  A longer-term rally could test the $1.3475 level, which is the 61.8% retracement of the May high to the June low.

Overall, the FOMC meeting is a major event for financial markets. However, now that Governor Warsh has disbanded with forward guidance, we expect the major reaction to come from the rate decision. We so not expect a large impact on asset prices from his press conference, as Warsh is expected to give away little information about the Fed’s future policy path.

Chart 1: GBP/USD daily chart