Kutilaneethi

The U.S. Federal Reserve hiked rates 25bps to 1.50% and said the U.S. economy is about to grow stronger again. The statement that accompanies the rate hike also touched on a few other points – namely: that high oil prices are a matter of concern; there has been a period of slowdown, but that it will be transitory; and that the Fed will move at an optimal pace on policy – slow if need be, fast when required. One important implication of the FOMC statement is that the Fed expects oil prices to ease back down. They attributed the recent slowing in growth 'importantly to the substantial rise in energy prices' and yet they state the economy 'is poised to resume a strong pace of expansion going forward'.

Thus if oil prices persist at current record high levels or climb higher, the Fed will have to consider the dampening impact on growth. That would imply that the U.S. central bank could hold rates at 1.5% in September. Judging by the high degree of similarity between the June 30 FOMC statement and the one issued on August 10, the Fed does not appear worried about the risk of a sustained slowdown in growth as many on Wall Street seem to be. The Fed appears confident growth and hiring will rebound in the coming months.

The statement maintained their intention of proceeding at a measured pace, it called their stance accommodative after the move to 1.5%, it unsurprisingly still saw inflation pressures of H1 as transitory, it noted some slowing in growth and labor conditions (attributing this to higher energy prices) but asserted that the economy is poised to resume stronger growth. It is this latter assertion, although a subtle nuance, that has disappointed bond traders in the midst of a quarterly refunding at overly optimistic interest rate levels. The balances of risks were left roughly equal.

The statement was a bit of a disappointment to bond traders, especially those carrying long positions, and looking for more hints of concern about growth and maybe hints of a pause in rate action at the September meeting. This statement is squarely in line with my outlook, couched in a manner that is more supportive of the U.S. dollar and stocks (strong growth still likely with low inflation).

But don’t go out and celebrate a September rate hike. Not just yet anyway. As we have stressed, if Greenspan is to succumb to political pressure and skip September, he will almost certainly package the move with low inflation rhetoric or will cite the increasing risks of higher energy prices. Therefore, if oil prices do back off, it is essential that all data related to inflation (CPI, PCE, PPI, Wage data etc) is supportive of their view that first half inflation pressures will prove transitory.

Otherwise, the Fed will be under intense pressure from the market to raise rates again before the election. If oil prices persist at near record levels, the Fed could cite new risks to the consumer and business outlook.