Fed: The Brexit Factor

Published on May 25, 2016

Key Takeaways:

•    An FOMC majority believes economic conditions will warrant a mid-year rate hike, and while agnostic whether in June or July, on balance, FOMC caution could tip to July.

•    Above all, the premium will be on maximum policy flexibility for a rate decision at the June meeting, so we would still put the odds of July over June as only slightly better than even.

•    Chair Yellen may preview the Fed’s thinking and approach to the Brexit risk in her June 6 speech in Philadelphia.

With the market now pricing in much higher probabilities of a mid-year rate hike by the Federal Reserve, attention is quickly turning to whether it could come at the June or July Federal Open Market Committee meetings, with the UK’s June 23 “Brexit” vote on whether to leave the European Union looming large as a key factor.

*** There is a very solid Committee majority consensus for a mid-year rate hike (SGH 5/17/16, “Fed: June Messaging”), but the FOMC is for now essentially agnostic on whether the likely rate hike comes in June or July. It will be a purely tactical decision, with a premium on flexibility to make the decision at the June meeting itself. Chair Janet Yellen may opt to signal the Fed’s approach on the Brexit risk in her June 6 speech. ***

*** Even if the FOMC concludes the Brexit odds are low or falling, there is perhaps a very modest lean within the Committee towards a July rate move. Since it matters little to the policy normalization path whether a hike comes in June or July, a later move is seen by many in the FOMC as a prudent safeguard against an excessive tightening of financial conditions, especially in a sharp dollar appreciation, if the UK should vote to exit. ***

*** And while we would still put the odds of July over June as only slightly better than even, there are two additional benefits to a July move that may enter into the FOMC deliberations worth noting: it would allow more time to see if the data do indeed confirm the baseline forecast for above trend growth and a tightening labor market, and it would provide a convenient opportunity to show the markets the FOMC can hike at a non-presser meeting. ***

A Date-Specific Binary Risk

Much has been made of the Fed’s seemingly newfound sensitivity to global developments and risks. That, of course, was certainly evident in the March meeting hesitation to follow through on the first of four rate hikes projected in the December rate dot plot. But many Committee members, perhaps a majority and certainly including the Chair, were never comfortable with the four rate hike scenario, and in some sense the violent market turbulence in January and February only confirmed their uneasiness.

Indeed, by the time of the March meeting, many of the more hawkish Committee members felt somewhat chastened, and began to reassess the pace of policy normalization. By March, the rate projections came down across the FOMC projections in order to protect the above trend growth forecast. At the same time, in the wake of the market turbulence and excessive gloom that prevailed at the time, it was relatively easy for a Committee consensus to solidify around the heightened risk management-driven caution that “financial and global conditions continue to pose risks.”

The risk the FOMC will be weighing at their June meeting in the UK vote whether to leave the EU, however, does not carry the same sort of threat to the US outlook as the more general overhang of downside risks in a China stumble, for instance, that dominated the FOMC discussions in the first quarter.

For one, Brexit is a very binary, date-specific risk, more akin to Y2K in 2000 or more aptly, the late 2013 risk of a default on federal debt when the GOP-controlled Congress threatened not to increase the federal debt ceiling. That called for some degree of Fed contingency planning at the time, but no change in the thrust of policy.

In the same way, the Brexit vote could come and go with a whimper rather than a bang. Or if against the current odds the British voters opt to exit the EU, even then, the longer lasting repercussions would be almost impossible to pre-emptively best guess or model in any meaningful way.

The primary concern over a UK exit from the EU — which would be negotiated over the next several years — is invariably what it might mean in an undesired or excessive tightening in US financial conditions due to potential capital flight into the dollar and treasuries.

But in any case, how those repercussions might play out would be factored into future forecasts and policy adjustments rather than driving a near term policy decision. In that sense, the Brexit vote would not necessarily preclude a rate move this summer.

Tactical Considerations

There, however, could be near term volatility risks in the run up to and or in the immediate wake of the Brexit risk date, and if excessive the week of the June meeting, it would warrant a pass on the rate hike simply to avoid adding to potentially destabilizing market dislocation — a tactical consideration in other words.

So while the FOMC will certainly be weighing the odds on a UK leave vote, the potential impact on the market, and the possible repercussions on the US outlook, the FOMC is wholly indifferent to whether they vote to raise rates at the June or July meeting when it makes little difference to the overall policy path being mapped out in the policy normalization strategy.

Assuming the Committee concludes the conditions warrant a second rate hike, which seems likely, they could raise rates a second time at the June meeting and use the press conference to explain the reasons and the near term outlook, including the Brexit factor; or the FOMC could still opt out of a sense of prudent caution that it would be safer to wait for the Brexit dust to settle, and to use the presser again to explain the tactical calculations but to signal the high probabilities of following through with the intended rate hike in July.

In other words, the premium is on creating maximum policy flexibility for the rate decision at the June meeting.

And that, we suspect, could enter into the drafting of Chair Yellen’s June 6 speech, as one means of ensuring the market is fully on board with the reasons behind a high likelihood of a summer rate move and that a prudent delay until July could be in the cards.

But a delay would in any case be a purely tactical option to consider and debate at the June meeting, more as safeguard against unintended consequences rather than indicating any ambivalence on the merits of a second rate move or the policy normalization strategy itself

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