What Next, If Fed Hikes Rates in December?

At a Glance

  • Probability of a rate hike is about 75 percent
  • Effect on U.S. economy, Dollar will be minimal

 

The message is now more transparent from Federal Reserve Chair Janet Yellen.  In her many speeches of late, she has articulated with considerable clarity the path the Fed is likely to take as the U.S. central bank seemingly edges closer to raising short-term interest rates for the first time in nearly a decade.

The federal funds rate has remained near zero since the Great Recession of 2008 that plunged the country into an economic panic, causing the Fed to initiate a number of asset-purchase programs called Quantitative Easing in a bid to revive the world’s largest economy.

We, like many analysts, expect the Fed to raise rates at the meeting of its Federal Open Market Committee (FOMC) scheduled for 15-16 December 2015. Based on Federal Funds futures prices, there is roughly a 75 percent probability the Fed will raise rates at this meeting, up from about 70 percent in November, and way up from just after the Fed passed on raising rates in September 2015 due to fears about the Chinese stock market and economic slowdown.  With the solid jobs data in the U.S., the Fed has returned to a focus on U.S. data to drive monetary policy than letting itself be swayed by the highly volatile Chinese stock market.

With the Fed’s decision to raise rates in December almost a foregone conclusion at the moment, the next crucial point to consider would be the path the Fed takes in 2016 on ensuing increases. For this, Yellen has indicated that the Fed would use inflation data for guidance.

By the way, when it comes to gauging inflation, the Fed prefers to use a consumption expenditure measure of inflation instead of the headline consumer price index numbers. With general inflation now at 0.2 percent, and core inflation (excluding food and energy) at 1.3 percent, based on the consumption expenditure measures, will the Fed raise rates?

Our perspective is that we will see incremental gains in U.S. inflation measures in the first half of 2016, as year-over-year comparisons for energy prices will no longer show big drops.  Still, we are only talking about getting into the 1.5 percent to 2 percent range for inflation.  Taking this subdued outlook for inflation into consideration, the federal funds interest rate could only be at 1 percent or so by the end of 2016.  The Fed may be abandoning its zero interest rate policy that was borne out of the Great Recession, but it is not going to raise rates quickly or in lockstep.

The impact of a rate hike on the U.S. economy will be next to nothing.  The difference between 0 percent and 1 percent is not enough to move the needle on corporate investment plans or consumer spending one way or the other.  And, the impact on the U.S. dollar may even be counterintuitive to some, as this is really a very weak policy step, and so the euro might even rally a little.

One other market change which we will all have to watch is whether the monthly inflation data, typically released mid-month, starts to become more heavily monitored. For now though, the employment data released on the first Friday of each month is still king – for market activity.

A final note is that the pace of inflation will also influence the evolution of the U.S. 10-year Treasury yield and other long-term bonds. Subdued inflation suggests a flattening yield curve (little to no movement in bond yields) even as the Fed abandons zero rates.

Bluford (Blu) Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. He is responsible for leading economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact. Prior to joining CME Group, Putnam gained more than 35 years of experience in the financial services industry with concentrations in central banking, investment research and portfolio management. He has authored five books on international finance.

Additional Recent Articles in Global Finance