Expect the Fed to Favor a September Rate Hike
The Federal Reserve's Open Market Committee meeting this week will be particularly notable if central bank officials signal Wednesday that they are inclined to embark on a new interest rate cycle in September, raising floored policy rates for the first time since 2006.
I expect the central bank to show it is leaning toward a hike, after weighing these five considerations:
- Economic Outlook: The Fed has to balance mixed economic data with the more solid indicators from the labor market, including robust job creation and, after an unusually long lag, a pickup in wage growth and the participation rate.
- Inflation Prospects: Although the threat of outright deflation has receded, if not disappeared, the “low-flation” risk remains. Fed officials will assess whether, and how quickly, stronger economic drivers could return inflation to the 2 percent target.
- International Context: The Fed in recent months has become more sensitive to adverse spillover from a fluid global economy, amplified by the deterioration in the long-running Greek debt drama. The U.S. economy is exposed in two ways: weak international demand that holds back export growth, and the prospects of renewed dollar appreciation that would place further price pressures on exports and on domestic products that compete with imports.
- Financial Stability: Fed officials continue to walk a particularly fine line. On the one hand, they fear dislocating markets by prematurely withdrawing too much of the long-entrenched hyper-stimulative policy that has made central banks around the world the best friends of investors. On the other hand, they worry that the protracted suppression of interest rates encourages excessive risk-taking, distorts asset allocation and may have excessively decoupled financial assets from the economy's fundamentals.
- Liquidity Risk: Concerns about financial stability are amplified by a growing appreciation of structural changes that have eroded market liquidity, particularly at turning points. Recent sharp movements in what are traditionally the most staid markets, those for “riskless” government bonds such as German bunds and U.S. Treasuries, have served as a warning. The threat of unusual volatility will persist as long as the risk-absorption capacity of broker-dealers -- and in particular their willingness and ability to deploy their balance sheets -- can't match the collective desire of end-investors to reposition when market paradigms change.
Weighing all this together, I expect the Fed to signal its openness to raising interest rates at the FOMC's September meeting in a qualified manner.
Central bank officials will draw comfort from the strengthening of the labor market, which is likely to stimulate economy-wide consumption and investment, and push inflation higher over time. While they will be monitoring international developments closely, these are unlikely to stop an interest rate hike, especially if the dollar remains relatively well-behaved. Meanwhile, concerns about undermining the appetite of investors for risk will be tempered by caution about goosing markets much more, particularly given patchy liquidity.
Yet don’t expect the Fed to signal its rate path in a deterministic manner: officials will make a point of retaining some flexibility and options.
Look for the signaling of higher rates to come with a notable qualification: At this meeting and over the next few weeks, Fed officials are likely to make remarks aimed at conveying both the still-tentative nature of the schedule for the first rate rise and to emphasize that the subsequent journey will be shallow and conditional, and will end with unusually low rates from a historical perspective.
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