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With a British adieu to EU, it's farewell to a Fed rate hike for now

[June 24, 2016] By Ann Saphir

SAN FRANCISCO (Reuters) - The U.S. Federal Reserve, already undecided on when next to raise interest rates, now has one more reason to wait: Britain's vote on Thursday to leave the European Union.

Not that the Fed needed another reason.

Weaker-than-expected growth in U.S. jobs in recent months had already forced U.S. central bankers to put off a rate hike at their meeting last week.

But while data due early next month on June U.S. payrolls growth could help clear up doubts about the strength of the labor market, the political and economic consequences of Britain's exit from the EU will take months or years to unfold.

Financial markets have already spoken, emphatically, in the hours since the 'leave' outcome in the so-called Brexit referendum became evident. U.S. equity index futures plunged and investors rushed for the safety of U.S. Treasuries, pushing the yield on the benchmark 10-year note below 1.5 percent, nearly a four-year low. The dollar rose by more than 3 percent at one stage, the most in a day since 1978. [MKTS/GLOB]

Interest rate futures markets rallied so hard that they have erased any probability of an increase in the Fed's benchmark overnight lending rate for both this year and next. In fact, they are pricing a possibility that the federal funds target rate may be lower in December than it is now, which is around 0.38 percent on average.

"It adds weight to the camp that the Fed would be on hold. A July (hike) is definitely off the table," Mike Baele, managing director with the private client reserve group at U.S. Bank in Portland, Oregon, said of the latest Brexit results.

BREXIT ON THEIR MINDS

The Fed's recent playbook suggests central bankers will opt for caution.

Market volatility in the past year, a stronger U.S. dollar in the past couple of years that has crimped exporters profits, low oil prices and inflation, and weaker economic growth in U.S. trading partners have kept Fed monetary policy on hold at least twice in the past year.

Fed officials' comments in the run-up to this week's British referendum signal this time will be no different.

A Brexit could "negatively affect financial conditions and the U.S. economic outlook," Fed Chair Janet Yellen said a few days before the referendum.

"Financial conditions could tighten," said Fed Governor Jerome Powell said the day before the vote, adding that "global developments, global weakness ... are really important for the setting of U.S. monetary policy."

Neither, however, gave any indication how big an impact the decision might have, and the Fed has no plans for an emergency meeting in the event of a leave vote, Chair Janet Yellen said this week.

"It depends on how bad things would get and for how long they would stay bad," said Roberto Perli, a partner at Cornerstone Macro LLC and a former Fed staffer. "The problem with trying to handicap outcomes here is that there are too many unknowable unknowns."

A British departure from the EU would deprive the 28-member EU of its second-biggest economy and one of its two main military powers, sending political shockwaves across the continent. The "Leave" campaign says Britain's economy would benefit from a Brexit. The "Remain" camp says it would cause financial chaos and impoverish the nation for years or even decades to come.

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Federal Reserve Board Chair Janet Yellen testifies before the Senate Banking Committee at Capitol Hill in Washington, U.S., June 21, 2016. REUTERS/Carlos Barria -

GLOBAL SENSITIVITIES

Joe Gagnon, a senior fellow at the Peterson Institute for International Economics, expected the Fed to raise rates once this year, so long as the British opted to remain in the European Union.

But a Brexit, he said, will throw the U.K. into recession, slowing U.S. exports, payrolls expansion, economic growth to "the equivalent of at least a 25 basis point hike" in Fed interest rates, Gagnon said. "It could mean no rate hikes this year."

If the slowdown deals a severe blow to Europe, which in Gagnon's view is a less likely outcome, the Fed could be forced to delay interest rate rises further.

However, not all subscribe to that view. Capital Economics economist Paul Ashworth, for instance, predicts a "trivial" impact on the U.S. economy, given that U.S. exports to the U.K. account for less than half a percent of GDP.

"Leave or remain, this probably isn't going to affect Fed policy," he said.

Yet global events have repeatedly stayed the hand of the Yellen Fed, which is already loathe to do anything to curtail what has been a modest recovery from a deep recession in 2008.

In late 2015 the Federal Reserve deferred an expected interest rate rise after global markets swooned in response to an unanticipated slowdown in China's economy.

Earlier this year, Fed officials cited tighter financial conditions brought on by further heightened worries about China as another reason for caution.

Eventually, however, U.S. employment, wage rises, inflation and economic growth will likely enable the Fed to normalize interest rates, even though the full impact of Brexit won't be known for years.

"(Fed policymakers) can’t just put policy on hold for several years – that’s not going to happen," Gagnon said.

(Reporting by Ann Saphir; Editing by David Chance and Dan Burns)

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