Good morning, and happy Federal Reserve Day to all who observe. The dollar is holding firm, with investors and economists overwhelmingly convinced the Fed will raise rates for the first time in more than three years, amid a surge in global energy prices and a jump in long-term yields. Oil remains above $100 a barrel after Saudi Arabia, after coming under sustained attack from Iran and its allies, suspended loading at its Yanbu port and cancelled some shipments to Europe. Ten-year Treasury yields are holding just below 5%, and equity futures are edging higher ahead of the North American open.
The case for a rate hike today is clear. The labour market is stable, with unemployment holding near historically-low levels as hiring keeps pace with slowing growth in the workforce. Price pressures are stubbornly high: the Fed’s preferred inflation measure, the core personal consumption expenditures index, has climbed on a markedly steeper path in the 2020s, and with the war in Iran pushing up energy costs, tariffs lifting import prices, and the artificial-intelligence boom supporting demand, shows no sign of slowing. At Jackson Hole last month, chair Kevin Warsh said “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”
The economic impact should be bearable. This morning’s retail-sales report is expected to show consumer spending remaining robust; business investment remains strong, albeit heavily concentrated in technology; and financial conditions are, by any measure, loose, with the recent surge in bond yields more than offset by tightness in credit spreads and buoyancy in risk assets.
How markets will react is less obvious. Since Paul Volcker’s time, the Fed has aborted a rate hike cycle after a single move only once—in March 1997, just ahead of the Asian financial crisis, Russia’s default and the collapse of Long-Term Capital Management—so it is reasonable to expect additional hikes to follow. A clearly-telegraphed tightening trajectory, perhaps set out in the “dot plot” summary of economic projections, could anchor interest rates and the dollar higher. But by signalling its resolve to bring inflation down, the Fed could equally ease the upward pressure across the curve and blunt any exchange rate gains. And Warsh—famously wary of providing anything resembling “forward guidance”—may struggle to out-hawk a market that has doubled tightening expectations since July. Currency markets could snooze through the event, or exhibit whiplash-like price action between the statement and the post-decision press conference.
The pound is almost unchanged against the dollar after underlying inflation held steady last month, reinforcing expectations that the Bank of England will stay on the sidelines in tomorrow’s decision. According to the Office for National Statistics, the core measure of annual price growth, which strips out energy and food, held at 2.6% in August for a fourth straight month, while the headline rate accelerated to 3.1%, from 2.8%, as gasoline and household electricity prices climbed. Data published yesterday showed job vacancies in the three months to August falling to their lowest, outside the pandemic period, since 2014, payroll employment shrinking, and wage growth slowing. Traders expect the Bank to leave rates unchanged while signalling a November move, contingent on energy prices staying high.
The Canadian dollar remains on the defensive even after prime minister Mark Carney unveiled sweeping business-tax reforms at yesterday’s Canada Investment Summit, letting firms write off the full cost of a broad range of new investments. According to the government, Canada’s marginal effective tax rate on new business investment will fall to 6.4%, from 13%—the lowest in the G7, and roughly half the US rate. The move is unlikely to worsen Canada’s fiscal position materially—the government estimates the marginal cost at C$36bn over five years, and Canadian deficits are dwarfed by those of the US. But front-loaded capital spending that lifts growth expectations, together with a stronger case for foreign direct investment, should lend the currency some support at the margin, particularly if it strengthens the case for tighter Bank of Canada policy. As we have argued, although a broad-based recovery in the dollar will keep the loonie on the back foot for now, with gains capped in the near term by trade uncertainties, the outlook into next year is brightening, putting the pieces in place for an eventual recovery.
