Bottom Line: Despite dovish comments from Dudley and a more dovish Lockhart earlier in the week, our US economics team are still calling for a September rate hike. Given the market is only pricing in 15% probability of a hike in September and less than 50% chance of a hike by year end, this is quite an out of consensus call. Our baseline forecast is that markets calm over the next three weeks, data stays positive and Fed hikes in September.
We expect 2Q GDP growth to be revised up from 2.3 to 3.4% today and we continue to track 2.8% growth in 3Q.
More important, the Fed is clearly putting a big emphasis on the labour market and they are getting just what they want:
· Payroll growth has averaged 211k this year and shows no sign of slowing.
· Both the narrow (U3) and broad (U6) unemployment rate continue to trend lower, falling 0.3 and 0.8% respectively this year.
Inflation remains low, but “the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labour market improves further and the transitory effects of earlier declines in energy and import prices dissipate.”
Stripping out energy and import prices, PCE inflation is running at about 1.5% and is inching higher. As we have argued, the Fed seems to be relying on the job market to meet both its employment and inflation objectives.
Given the stark contrast between the domestic data and the markets, this is one of those moments where it is important to consider multiple scenarios:
(1) Our baseline forecast is that markets calm over the next 3 weeks, data stays positive and Fed hikes in September.
(2) Market turmoil is slow to abate, but data remains healthy, delaying the first hike to October or December. This seems like the second most likely scenario.
(3)Market turmoil first delays the Fed, and then starts to have a significant negative impact on the macro data. This pushes out the first hike well into next year, or indefinitely.
Related Research
US Economic Watch: When the data say “go” but the markets say “no”
• We reiterate our baseline forecast for the Fed to hike in September: if markets settle down, the Fed is on track to exit.
• In the event of continued market turmoil, the Fed may push the first hike to Oct/Dec. This is a risk to our baseline.
• A more severe shock to the real economy (although this is not our base case) could result in a more notable delay.
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