Could the Fed's Promise of "Gradual" Tightening Mean 0.125% Rate Hikes?

Regardless of their preferred asset class, the single most important question on traders’ minds is “When will the Federal Reserve start raising interest rates?” Investors and analysts (yours truly included) filter each new data point through the lens of the Fed’s interest rate policy and try to determine whether each report means the central bank is marginally more likely to raise interest rates in September, December, or next year. However, as we’ve argued in our special report “Fed Up with Low Interest Rates,” the pace of interest rate increases is far more important than the precise timing of the first rate hike.

When it comes to the speed of tightening, Fed policymakers have been characteristically vague but uncharacteristically unanimous, repeatedly warning that the pace of tightening will be “gradual.” In the last week alone, both FOMC Chair Yellen and Vice Chair Fischer have used near-identical wording in describing the tightening process:

• Yellen: “If the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate…I anticipate that the pace of normalization is likely to be gradual.” (She later said that the Fed would proceed “cautiously” and that it would take “several years” before the federal funds rate returns back to its normal, longer-run level)

• Fischer: “Which is better, early and gradual or late and steep? If we raise the rate from zero it will be harder to go back to zero if there is a problem. Our processes are not date-determined, they are data-determined… This will be a gradual process." (He too noted that it could take three to four years to bring interest rates back to normal levels and drew a direct contrast between the current tightening plan and the rate hike cycle from 2004 to 2006, when the central bank increased interest rates by 0.25% at 11 consecutive monetary policy meetings)

The market consensus has taken these comments to mean that the Fed will stagger its interest rate hikes, perhaps raising the Fed Funds rate by 25bps, then waiting for two months, then opting for another interest rate hike if the economy hasn’t faltered. But given the Fed’s emphasis on predictability and limiting market disruption, the central bank could also opt for consistent, smaller-than-usual 0.125% rate hikes, especially early in the tightening cycle. After seven years of interest rates at 0%, a “baby step” of a rate hike may help smooth the transition into the tightening process and minimize any economic disturbance.

There is precedent for miniature rate hikes, as the Fed itself raised interest rates by less than a quarter-point under Alan Greenspan as recently as 1989, and many EM central banks (including Hungary’s National Bank) routinely tweak interest rates by as little as 0.10%. That said, some argue that such a move borders on hubris that a central bank can precisely control the trillions of transactions among volatile “animal spirits” that drive the US economy. For what its worth, Fed Funds futures contracts are currently pricing in a 62% chance of a 25bps increase by December, which is equivalent to .0155% or about an eighth-point rate hike.

How Would a 0.125% Rate Hike Impact the Markets

Of course for traders, this theoretical discussion only matters to the extent that it impacts markets. In our view, a 12.5bps cut would increase transparency and allow the Federal Reserve to get off the 0% lower bound while minimizing market dislocation. Most importantly, the potential for more gradual changes in interest rates could decrease the volatility surrounding FOMC meetings as we get into Q3 and Q4 and could allow the dollar to continue its longer-term uptrend; after all, even a 12.5bps rate hike is more than any other G10 central bank is considering.

In saying all that, the eighth-point rate hike scenario is still not our base case for the august and tradition-driven institution, but traders should always be thinking one step ahead of the consensus and preparing for alternative developments so they’re not caught off guard.