The Shifting Case for a Fed Rate Increase in March

Markets will be looking to Federal Reserve Chair Janet Yellen’s congressional testimony today and tomorrow to confirm expectations that a March interest-rate increase is a remote possibility. Yet those expectations could be upended: Yellen is likely to strike a cautiously hawkish tone, as she did in previous testimony and Fed press conferences. In addition, inflation risks are rising, and the labor market has strengthened significantly.

Markets responded to the monthly jobs report on Feb. 3, 2017, as if it was dovish for the Fed, but it wasn’t. Although wages rose a modest 2.5 percent in January from a year earlier, and the unemployment rate rose marginally to 4.8 percent from 4.7 percent, the trend of an improving labor market remains unchanged. And jobless claims are extremely low: The average number of applications filed over the past four weeks reached the lowest level since 1973.

Since the end of its quantitative easing program, weak inflation has held back the Fed from raising rates at a faster pace. Even now, expectations for policy remain somewhat dovish. The odds of a rate hike on March 15 are being discounted by financial markets, even though the February Fed statement indicated greater conviction about inflation rising to 2 percent. In one of the few changes of wording, the statement removed all qualifying language regarding higher inflation that had been present in the December statement, including references to energy prices, import prices and the tightening U.S. labor market.

Apparently, qualifiers are no longer needed to justify expectations that inflation “will rise to 2 percent in the medium term.” Because of this hawkish change, even if the Fed doesn’t raise rates on March 15, the “dot plot’’ for rates is likely to rise for 2016 and 2017.