Hilsenrath’s Take: ‘Brexit’ Vote Means More Fed Delay

Market mayhem and the strengthening U.S. dollar following Britain’s decision to leave the European Union make it increasingly likely the Federal Reserve will delay plans to raise short-term interest rates.

Officials just a few weeks ago were looking at a move by their July 26-27 policy meeting. That now looks highly unlikely and a move at subsequent meetings becomes less likely too, at least until it becomes clearer how events in Europe will affect the U.S. economic outlook.

“The Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union,” the U.S. central bank said.

The most important development from the Fed’s perspective is a sharp rise in the dollar, which rose 3% against a broad basket of currencies before retreating as U.S. trading commenced.

The strengthening dollar is in effect a policy tightening for the U.S. that hurts exports and puts downward pressure on import prices. Stock market declines and the global flight from risky assets add to this tightening effect.

“A continued appreciation of the dollar could be the most serious channel of contagion to global markets,” Roberto Perli, an analyst with Cornerstone Macro, a policy research firm, said in a note to clients.

Among its effects, he noted, the stronger U.S. currency puts pressure on Chinese officials to allow the yuan to weaken. Yuan weakness in the past, in itself, has been a source of market volatility that drove the Fed to delay rate increases.

The latest developments will surely make Fed Chairwoman Janet Yellen, a cautious and risk-averse central banker, more reluctant to raise the central bank’s benchmark federal funds interest rate, an overnight bank lending rate. Lifting it would amplify market volatility and upward pressure on the U.S. currency.

“The U.K. vote to exit the European Union could have significant economic repercussions,” Ms. Yellen told Congress this week. A so-called Brexit would “usher in a period of uncertainty” and fuel volatility in world markets. “That would negatively affect financial conditions and the U.S. economy,” she added.

If it becomes clear the U.S. economy has been lastingly and adversely affected by the U.K. decision and the Fed’s forecasts for modest growth and a rise in inflation are seriously downgraded, it is possible the Fed could cut U.S. interest rates, moving them closer to zero.

However, Ms. Yellen would likely come to such a decision slowly. Instead, the Fed’s first instinct is likely to be to take a stance of watchful waiting.

If markets settle and the dollar’s rise is stemmed, the impact of the British vote could be modest. Bank of America analysts revised their estimate of U.S. output growth down only slightly — 0.2 percentage points over the next 18 months — in light of the U.K. vote. They see the economy growing at a rate of 1.8% next year, compared with 2% before the vote.

Traders in fed funds futures contracts on the Chicago Mercantile Exchange put zero probability of a Fed rate increase in either July or September and a 2% chance on the Fed reducing rates by a quarter percentage point in both of those months. They saw a 19% chance the Fed would move rates up a quarter percentage point by year-end and a 79% chance the Fed will keep rates unchanged through the end of the year.

The Fed in December moved its benchmark federal-funds rate from near zero to between 0.25% and 0.5%. Central bank officials released projections last week showing they expected to raise the rate by a half percentage point by year’s end, though they have never committed to a specific timetable.

Meanwhile, the Fed has set up U.S. dollar swap lines with five global central banks — the Bank of England, European Central Bank, Bank of Japan, Swiss National Bank and Bank of Canada — through which it can make dollars available to financial institutions overseas if the vote spins into a crisis.

These lines were heavily used during the financial crisis, drawing more than $500 billion at their peak. They haven’t been tapped much in recent years, but they are in place and could be drawn upon if banks overseas become desperate for dollar funding.

“The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy,” the Fed said in its statement.
Source: John Hilsenrath / Dow Jones Newswires


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