How Fed officials are likely to weigh Greek crisis impact

A Greek exit from the euro zone could give Federal Reserve policy makers reason to put off an interest-rate increase. Some investors are already betting on a delay.

Federal funds futures traders reduced the probability of a September increase to 35 percent on Monday in New York from 45 percent Friday. The yield on the 10-year Treasury note dropped by the most since October.

Whether those bets are correct will depend on how turmoil in the euro zone plays into Fed officials’ forecasts for growth, employment and interest-rate increases this year.

Chair Janet Yellen made it clear in her June 17 press conference that she needed to see “more decisive evidence” of sustainable economic momentum that supports labor markets and gradually firming prices. While economic data have improved since then, New York Fed President William Dudley called Greece a “huge wildcard” for the U.S. outlook in an interview with the Financial Times published Sunday.

Here’s what Fed officials will be watching in the weeks ahead:

▪ Contagion: One immediate risk is a slump in business and consumer confidence in the euro zone that undermines the region’s economic recovery and increases risk-aversion elsewhere.

“The Fed is concerned because they see these problems in Europe and in the world economy as basically a drag,” said Joseph Gagnon, a former Fed economist and now a senior fellow at the Peterson Institute for International Economics in Washington.

U.S. central bankers next meet July 28-29. Yellen’s next two press conferences will follow the September and December meetings.

▪ The exchange rate: One of the biggest surprises for economists in and outside the central bank was how swiftly the 18 percent rise in the dollar against major currencies for the year ending March sapped U.S. gross domestic product.

A stronger dollar cuts into exports by making U.S. goods more expensive abroad, while making imports cheaper. A ballooning trade deficit cut 1.9 percentage points from GDP in the first quarter of this year and about 1 percent in the fourth quarter of 2014, the biggest back-to-back drag since the first half of 1998.

Greece’s impact “will depend on the market reaction, especially the dollar,” said Mark Spindel, chief investment officer at Potomac River Capital, a hedge fund in Washington with $750 million under management. “We know how sensitive the Fed committee is to dollar strength.”

▪ Financial conditions: Fed stimulus works through financial markets by lowering financing costs on everything from cars to homes. U.S. Treasury notes rallied Monday, pushing the yield on the 10-year note down to 2.33 percent at 3:05 p.m. in New York from 2.47 percent late Friday.

The question is whether mortgage and corporate financing become more expensive relative to Treasury yields as lenders grow more risk averse.

Fed officials “need to see where mortgage-backed security spreads and corporate spreads are to Treasuries” and what happens to stocks, which influence consumer confidence and spending, said Michael Gapen, chief U.S. economist at Barclays Capital Inc. “Those are your primary starting points” as a policy maker, Gapen added.

This story was originally published June 29, 2015 at 6:00 PM with the headline "How Fed officials are likely to weigh Greek crisis impact."