In general, more financial stress means tighter financial conditions, and those tighter financial conditions can mute the impact of the Fed’s very accommodative monetary policy, and in severe cases, restrict the flow of credit from the U.S. financial system to consumers and businesses. Similar to the direct impact of uncertainty in the U.K. and EU on the U.S. economy, the longer the financial stress in the system persists, and the tighter financial conditions get, the greater the potential damage to the U.S. economy. Based on what we know today, we don’t expect financial conditions to tighten to levels seen during 2007–09; however, it is possible they tighten back to where they were in late 2015 and early 2016, if Brexit uncertainty persists beyond a few weeks.
Given both the direct and indirect impacts of the Brexit on the U.S. economy and financial system, we are now expecting the Fed to raise rates just one more time this year, potentially in December 2016. If the Brexit uncertainty lingers, putting more downward pressure on the U.S. economy and inflation and more pressure on financial conditions than we now expect, it is possible that the Fed could choose to stay on the sidelines all year. Similarly, if the uncertainty around the Brexit in the real economy and in financial markets is short-lived, it is still possible that the Fed may do two more 25 basis point (0.25%) rate hikes this year, matching the forecast we made in November 2015. Three rate hikes by the Fed this year, which was a small possibility prior to the Brexit vote, now seems very unlikely
We will continue to watch the developments on the Brexit out of the U.K. and EU closely, and further discuss any direct or indirect impacts to the U.S. economy as needed in future editions of the Weekly Economic Commentary.
John Canally is chief economic strategist for LPL Financial.