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Just what is the Fed going to do about interest rates?

BofAML analysts still believe that rate hike is imminent; others call Fed “dithering”

After a week full of market volatility and upheaval, analysts from all sides are questioning what impact, if any, the events of the week are going to have on the Federal Open Markets Committee and the looming threat of rising interest rates.

As of now, uniform consensus is woefully lacking.

Earlier this week, New York Federal Reserve President William Dudley put the kibosh on any talk that the Fed may increase interest rates after next month’s meeting of the FOMC.

According to a Reuters report, Dudley said that the possibility of a September rate hike is now “less compelling” after the events of this week.

But those comments were in opposition to comments made Friday by two other Fed Presidents.

According to a Bloomberg report, Cleveland Fed President Loretta Mester said that the economy “can sustain” an increase in interest rates, while and St. Louis Fed President James Bullard said that one week’s market volatility should not affect an interest rate increase.

Fed presidents aren’t the only ones that apparently disagree on when interest rates are going to rise.

In a Friday note to clients, analysts from Bank of America Merrill Lynch (BAC) still believe the Fed is likely to raise rates in September.

In BofAML’s Securitization Weekly Overview, analysts Chris Flanagan and Mao Ding write that the BofAML house view is that the events of the last few days have not affected the likelihood that the Fed raises rates after the next meeting of the FOMC.

“The BofAML house view is that in spite of the market volatility of the past week, the most likely outcome is that the Fed will hike in September, even if there is some path dependency associated with the decision,” Flanagan and Ding write.

“In our view, the most likely near term path for risk asset prices is to the upside,” they continued. “If realized, this outcome should increase the chances of a September hike, which in turn is not likely to be viewed favorably by risk assets.”

The analysts write that the lesson to be learned based on this week is that “the Fed has acknowledged the need to respect market weakness in making its decision.”

The BofAML analysts suggest that Dudley’s comments show that the Fed has “tacitly acknowledged” that the week’s “market downside” is unacceptable, and posit that if the events of earlier this week are repeated, the Fed will back off the potential September hike.

“However, while that may be good news, the possibility that the Fed could still hike in September tells us that the upside is also limited,” the analysts write.

“Indeed, as equity markets rose further on Thursday, the market-implied probability of a September hike increased from 22% to 28%,” they continued. “Further gains in risk assets likely will be accompanied by further gains in rate hike probabilities, which should ultimately constrain the gains in risk assets.”

Despite the BofAML house prediction that interest rates are still likely to rise next month, Flanagan and Ding peg the likelihood of an increase at closer to “50-50.”

Analysts at Capital Economics also shared their reaction to the events of the week, telling clients that the “dithering Fed” is still waiting for the perfect conditions.

“We are now assuming that, even if the rally in global stock markets continues, some Fed officials will still want to hold off on raising interest rates until October or even December,” the Capital Economics analysts write.

“A September rate hike isn’t out of the question. But New York Fed President William Dudley’s comment last week that that case for a September rate hike was ‘less compelling’ than before was presumably a carefully crafted message,” they continue. “So until we hear otherwise, we have to assume that lift-off has been delayed yet again.”

The Capital Economics analysts write that an increase in interest rates is inevitable, regardless of when it actually happens.

“We‘re still convinced that core inflation will soon begin to accelerate,” the Capital Economics analysts write. “When that happens, the Fed won’t be able to use any more excuses and, given how long it has dithered this year, we still believe that interest rates will end up rising much more rapidly next year than others expect, with the fed funds rate finishing 2016 at more than 2%.”

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