In Brief

• U.S. Federal Reserve (Fed) officials have made it clear that they will consider hiking the fed funds rate in June.

• These signals from the Fed stem from a substantial shift in its perceptions of economic risks, an underlying need for rate normalization, and the central bank’s desire to manage market expectations.

• A move in June, however, is not a sure thing. Fed funds futures suggest a 30% chance of a hike, while some Fed officials believe that economic and labor-market conditions may not justify an increase.

• The key takeaway: Barring a surprisingly strong jobs report for May, we believe it’s more likely that a rate hike will come at the Fed’s July meeting.

The U.S. Federal Reserve (Fed) launched its interest-rate “liftoff” back in December, and now current markets are preparing for the possibility of stage two in June. Fed officials have made it clear that they will consider hiking the fed funds rate during the meeting of its policy-setting arm, the Federal Open Market Committee (FOMC), on June 14–15. Investors should manage their expectations accordingly.

Recent comments by Fed officials, combined with the release of the minutes of the April FOMC meeting on May 18, shifted investor expectations from a 4% chance of a June hike, prior to release of the minutes, to nearly 30% only one week later. While the Fed may prefer that expectations climb to around 60–70% before it pulls the trigger, economic and labor-related data releases prior to the June meeting could persuade more investors that a rate increase is both forthcoming, and appropriate. Even without that additional data, communications from Fed officials suggest that, from their perspective, the U.S. economy is in much better shape than many feared in February, and can withstand a tightening soon.

The Fed’s insistence that the June meeting is “live” in terms of a potential rate hike seems driven by a substantial shift in its perceptions of economic risks, an underlying need for rate normalization, and a desire to manage market expectations. The March FOMC statement and subsequent minutes were dominated by a new reference to “global financial and economic developments” and concern about U.S. economic growth. These factors seemed to postpone the likelihood of rate hikes, despite progress toward the Fed’s stated goals of 2% inflation (through rising wage inflation) and full employment (through 5.0% unemployment and rising workforce participation rates).

“Live” in June…
However, by the time of the April meeting, the Fed’s views had changed considerably. The April FOMC statement itself was benign, but the subsequent release of the April meeting minutes shocked investors with the extent of the Fed’s change in perception. The Fed started with a little self-congratulation: “The Fed recognized that [its] hesitation to hike rates helped firm markets.” Then the committee cited its changed view of the economy: “Several FOMC participants judged that the risks to the economic outlook were now roughly balanced,” and, looking forward, “[m]ost participants judged that if [economic growth, labor markets, and inflation improved]… then it likely would be appropriate to increase the fed funds rate in June.” The change in perceptions surprised investors. Expectations for a June rate hike moved higher. The April minutes provided the first evidence that June is a definite possibility when a rate hike could be considered.

It is important to remember, though, that changes in short-term interest rates are a key tool for the Fed, and the central bank likely wants to regain the use of that tool as soon as the markets will allow. Separate studies published by the Federal Reserve Banks of St. Louis and San Francisco Fed in 2015 each suggest that the Fed’s multiyear quantitative-easing program ended in 2014 was unsuccessful in stimulating economic growth. Thus, if at some point the U.S. economy is in jeopardy of relapsing into recession, the Fed would like to have a more normal rate structure, especially one with higher short-term rates, so that it can adjust and lower rates in order to help promote growth. The need for higher rates as a tool to influence future economic growth is at the heart of the Fed’s desire to adjust Fed funds when conditions permit. For this reason, too, June is “live.”

The Fed’s communication about the potential for a June rate hike is also consistent with the transparent culture promoted within the central bank over the past two decades. In this era, the Fed has not wanted to surprise markets with policy moves; rather, it seeks to manage market expectations, and then fulfill them. Bianco Research, for example, points out that since 1994, the Fed has not adjusted policy without the market having already priced in the expected action. It is not surprising, then, to witness repeated reminders by Fed officials that a rate hike in June is a consideration. The markets are starting to get the message.

…or Maybe July
However, a June rate hike is still far from a sure thing. Despite a chorus of Fed officials, including regional U.S. Federal Reserve Bank presidents Eric Rosengren (Boston), John Williams (San Francisco), Robert Kaplan (Dallas), William Dudley (New York), and Dennis Lockhart (Atlanta), suggesting that June is a possibility, investors still don’t see it as a probability. As of May 25, fed funds futures suggest less than a 30% chance of a June hike. Thirty percent falls substantially short of what the Fed might consider a fully discounted policy move. Policymakers may want expectations to broaden before rates are actually raised.

Other Fed officials may also have doubts about raising rates in June. The April FOMC minutes revealed concerns that “the recent slowdown in domestic spending might persist.” Regarding the goal of full employment, some members saw room for additional improvement in terms of reducing labor-market slack. Regarding the Fed’s goal of inflation, several committee members noted that “the stronger labor market still appeared to be exerting little upward pressure on wage or price inflation.” Further, they continued to see “important downside risks to inflation.” There seems to be room for progress on numerous issues before a rate hike is assured.