Fed at leisure with measured policy

This Wednesday will mark the end of an era. The US Federal Reserve is widely expected to announce a 25bp rate hike, one that brings to an end a four-year easing cycle and marks the beginning of the end of ultra low interest rates. Markets will doubtless scrutinise any minor changes to the wording of the accompanying statement. But there is a danger that markets will over-analyse. Within days, the statement could become outdated. In forecasting the future path of monetary policy, much still depends on this Friday's employment report.

Whilst Wednesday's handover of sovereignty in Iraq is sure to cause market jitters, the Fed should do its part to calm nerves by delivering on a well-signaled 25bps rate hike. The language they employ in their accompanying statement should be soothing. Given the amount of work the Fed has put into moulding market perceptions over recent weeks, it seems unlikely that the key phrase 'measured' will be dropped. That will give markets the confidence to price in another 25bp move in August.

The Fed may decide to shift to 'equal' rather than 'roughly equal' risks to sustainable growth. And they would be right to point out something firmer than 'hiring appears to have picked up'. Changes such as these represent recognition of unfolding realities. We think that there is a risk that markets may get too wrapped up in the language. The fact is that the Fed is still adopting a reactive strategy to the data. The employment report remains the major factor in defining Fed policy. Survey evidence suggests another big nonfarm payrolls number looks likely - we expect 270k jobs were added in June. Monthly gains in employment such as this more than make up for the breaking effect on consumer spending of a 25bp rate rise. But with hiring proving strong, the indicators of labour market slack now take precedence for the Fed. Any mention of rising, but still soft, unit labour costs will be watched for by the market. Strong growth is consistent with low interest rates as long as inflation remains benign. While a weaker US dollar and high commodity prices are creating pockets of inflation, the overall domestic picture looks remarkably soft. That is in no small part due to the amount of slack still evident in the economy, especially in the labour market. While unemployment is relatively low for this point in the cycle and already trending down, hourly earnings growth remains muted. And as long as that remains the case, the Fed is likely to maintain their'measured' approach to monetary policy.

We expect earnings to remain benign in June, rising just 0.2% m/m vs 0.3% prior. That would keep pressure off the Fed to become more aggressive in setting policy. But while the Fed is managing expectations well, their measured policy - as Greenspan pointed out just last week- is not set in stone. The statement might well tell us how the Fed would like to go about raising interest rates, but Friday's employment report will have a big say in defining how they will.