Market turmoil makes September rate hike 'less compelling': Fed's Dudley

By Jonathan Spicer

NEW YORK (Reuters) - A Federal Reserve interest rate hike next month seems less appropriate given the threat posed to the U.S. economy by recent market turmoil, an influential Fed official said on Wednesday in the clearest sign that fears of a Chinese slowdown are influencing U.S. monetary policy.

New York Fed President William Dudley said the prospect of a September rate hike "seems less compelling" than it was only weeks ago. However he warned about overreacting to "short-term" market moves, and left the door ajar to raising rates when the U.S. central bank holds a policy meeting on Sept. 16-17.

Dudley's comments, which briefly clipped the dollar and helped lift bonds and stocks, come a day before many of the world's top central bankers gather at an annual conference in Jackson Hole, Wyoming, to which investors will look for clues on how the turmoil may be rattling policy plans.

The comments were unprompted and made at a press briefing on the regional economy, suggesting they were a deliberate message from the broader Federal Reserve after a sharp two-day selloff in Asian, European and U.S. stocks.

The volatile selloff was brought on by weak Chinese economic data and concerns that authorities there are losing control of markets. Dudley said it threatens to crimp global growth and create financial conditions unsuitable for the Fed to soon hike rates for the first time in nearly a decade.

"At this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago," Dudley, a close ally of Fed Chair Janet Yellen, said of the policy-making Federal Open Market Committee.

But an initial rate hike "could become more compelling by the time of the meeting as we get additional information on how the U.S. economy is performing and (on) international financial market developments, all of which are important to shaping the U.S. economic outlook," he told reporters.

The market turmoil has called into question the Fed's long-telegraphed plans to raise rates from near zero this year and possibly as soon as next month. Investors and economists have predicted the Fed would delay the move until December or even next year, citing the rising dollar and falling oil prices, which has held U.S. inflation below target.

On Wednesday, traders closed out bets of an imminent Fed tightening, lifting the yield on 30-year Treasuries to its highest level in more than two weeks.

"This is a resounding signal that the probability of the September rate hike has diminished considerably, as Dudley acknowledged the external risks," said Mark Luschini, chief investment strategist at Janney Montgomery Scott in Pittsburgh.

HEIGHTENED RISK

Dudley, a dovish policymaker, was more direct in his warning than was Atlanta Fed President Dennis Lockhart, who on Monday said only that the rate hike was likely to come "sometime this year." Two weeks earlier Lockhart said he was "very disposed" to move in September.

While the U.S. labor market has been strong, prompting many Fed officials to consider hiking rates in September, inflation has been weak with little sign of rebounding.

Dudley said he wanted to see more U.S. economic data, and also how markets behave in coming weeks, before making a final judgment on the timing of policy tightening.

"International developments have increased the downside risks to U.S. economic growth somewhat," he said, with China's slowdown and falling commodity prices straining emerging markets and raising the possibility of slower global growth and less demand for U.S. goods and services.

The volatility has tightened financial conditions and widened credit spreads, he said, adding inflation remains "well below" the Fed's 2 percent target due to year-long moves in oil and the dollar, which he said should be transitory.

"It's important not to overreact to short-term market developments because it's unclear whether this will just be a temporary adjustment or something more persistent" that will affect U.S. growth and inflation, Dudley said.

Only a "large and prolonged" stock market drop could potentially weigh on Americans' willingness to spend, he added.

Asked about the possibility of a fourth round of stimulative bond-buying, or quantitative easing, Dudley appeared to chuckle and said the Fed is "a long way from" that. He added the market turmoil "is not a U.S. problem" and was sparked by "developments abroad."

Keith Berlin, director of global fixed income and credit at Fund Evaluation Group in Cincinnati, Ohio, said "markets have awakened to the realization that China's growth story is not what it once was." He added that the risk of a Fed policy mistake is now "materially higher than it was just a few weeks ago."

(Reporting by Jonathan Spicer; Additional reporting by Gertrude Chavez, Sam Forgione, and Richard Leong in New York; Editing by Meredith Mazzilli)