The FOMC meets next week to decide on interest rates. Analysts are split on whether the Federal Reserve will raise interest rates for the first time in nine years. The Committee itself also seems split. This reflects conflicting signals. Domestic economic strength signals that the Fed should act. However, a range of external forces – from emerging market risks, commodity prices and the dollar - suggests that it should keep interest rates on hold. On balance, we think the Fed will decide to wait. We expect an interest rate increase in December.
On balance, given these various arguments, we think the FOMC will opt to hold the target range where it is.
Nick Kounis Head of Macro Research
The most interesting FOMC meeting in years
As far as the outcome on interest rates is concerned, FOMC meetings for a number of years have been non-events. There was virtually no chance of any kind of move. The focus has been exclusively on Fed commentary to try and get hints about future policy. Next week’s meeting is different. There is a real chance of the first interest rate hike in nine years.
Analysts are split but edge towards a hike
According to the Bloomberg poll at the time of writing, economists are almost split down the middle on whether the Fed will move or not. Of the 81 economists in the survey, 39 expect the Fed to leave its target range for the fed funds rate at 0-0.25%. Meanwhile, 42 expect a 25bp increase, which would take the range to 0.25-0.5%. That means that on balance the median is for an increase, though it is a close call.
Markets tilted towards no change
Financial markets on the other hand, appear convinced that there will be no change. The fed funds rate usually sits in the middle of the target range. It is now at 14bp so if the Fed were to hike the fed funds rate, it should rise to just under 40bp. The implied federal funds rate from the October 2015 future sits at around 20bp. So markets are pricing in only a small chance of an increase in the target range. Separate calculations from Bloomberg imply that markets attach a 28% chance of a move next week. Though that rises to 60% at the December FOMC meeting.
FOMC members are also split
There is an old joke that if you put two economists in room you will get three different opinions. The split among market economists is also mirrored by vastly differing views among the members of the FOMC. At Jackson Hole, more hawkish members – such as James Bullard – argued that the Fed was still on course to raise interest rates in September, despite the market unrest. More dovish members – such as Bill Dudley – said that the case was now less convincing. The Vice Chair Stan Fisher sat on the fence saying it was ‘premature’ to make that call.
Arguments on both sides
The split in opinions reflects that strong arguments for and against raising interest rates, as well as the fact that the Fed has to balance progress towards a dual mandate, with the central bank aiming for both full employment and an inflation goal of 2%.
Robust economic growth
The case for a rate hike rests on the strength of the domestic economy. Economic growth has been quite volatile on a quarterly basis, but in the year to the second quarter, the economy grew by 2.7%. This almost certainly above the economy’s trend rate.
Labour market strength
This view is supported by labour market developments. Over the last year, employment has grown by around 240K each month, a very healthy level historically. Over that time, the unemployment rate has fallen by around one percentage point to 5.1%. It is at a relatively low level historically.
Very easy policy
The hawks will argue that strength of the domestic economy seems at odds with the Fed maintaining interest rates at around zero and real interest rates in negative territory. Those are measures for crisis times and the economy is returning to normal. It could also be argued that the Fed’s procrastination in raising interest rates is actually adding to the uncertainty.
Downside risks from China…
The case against the rate hike rests on a number of significant external risks. As we have underlined on these pages in recent weeks and months, there are significant risks surrounding the outlook for emerging markets. There is a risk that the slowdown in China’s economy is sharper than expected.
…and other emerging markets
This would pull down other emerging markets, which are already facing a range of challenges from (geo) political instability, to lower commodity prices. In addition, emerging markets are facing tighter financial conditions, partly because expectations of fed rate hikes have encouraged capital outflows and FX reserve liquidation, which leads to lower money supply growth.
These risks have fuelled unrest in financial markets globally over recent weeks. Although these are some signs of stabilisation, volatility remains high and sentiment remains fragile. So the doves would argue that it is better not to rock the boat.
Subdued inflation means there is no hurry
In addition, there is no need to hurry given that inflation is currently subdued and there are no signs of rising wage pressures. Indeed, low commodity prices have pushed down market inflation expectations (for instance as measured by the 5y5y inflation swap).
The balance of risks
Some members of the FOMC will argue that the cost of waiting is lower than the cost of raising rates too soon and having to reverse course. The low level of interest rates and limits to unconventional policy suggest that the Fed would lack ammunition in case of a new downturn.
We expect no change
On balance, given these various arguments, we think the FOMC will opt to hold the target range where it is. We think Chair Janet Yellen will want to have a strong consensus in the Committee in favour before moving. In addition, waiting a little longer until there is more information about the outlook for emerging markets and financial markets calm seems like almost a ‘free’ option. Finally, the ECB – and possibly – the BoJ – could soon step up monetary stimulus, and an early rate hike could trigger a surge in the US dollar. Our base case is that the Fed will raise interest rates at the December FOMC.
Fed likely to signal a slow path of rate hikes
Apart from the actual rate decision, the Fed’s communication on the future path of interest rates is crucial. The FOMC will publish new forecasts for the economic outlook and member views of the appropriate fed funds rate going forward (the so-called dot plot). In addition, Chair Yellen will conduct a press conference. Our sense is that the Fed will continue to signal that it will raise interest rates this year and then at a very slow pace thereafter.
Four hikes next year
After a December move, we expect to see four interest rate hikes next year, which means a move every other FOMC meeting. The target range would end up at 1.25-1.5%, with fed funds rate at around 1.4%. Current market expectations (from fed funds futures), imply an even slower pace, with the fed funds rate seen ending next year at around 0.8%