All speculations were laid to rest after the US Federal Reserve on 16th December announced its decision to raise interest rates for the first time in a decade. With this the Fed ended its prolonged zero interest rate regime. Not only that, it also became the first major central bank. Its euro zone, British and Japanese counterparts have either slashed rates or have held interest rates steady in their latest policy meetings.

The Fed decided to increase the Fed funds target range by +25bps to 0.25%-0.5%, in line with broad market expectations. The decision was taken considering the notable economic recovery that the US has seen in recent times. Fed Chair Yellen noted "With the economy performing well and expected to continue to do so, the committee judges that a modest increase in the federal funds rate is appropriate."

Fed interest rates

The consumer price index for November showed a rise in inflation to 0.5 per cent from 0.2 per cent recorded earlier. The data highlighted an improvement in the price environment. The unemployment rate has dropped to a seven-year low. It dropped for the second month in a row in November. The unemployment rate currently stands at 5 per cent. The figures signify a robust labor market. The economy is seen gradually progressing towards full employment. Wage growth has been healthy as well. Over the year, average hourly earnings increased by 2.3 per cent. 

Outlook for next fiscal year

The Fed expects the recovery at a steady pace in 2016 as well. The median forecasts for growth, employment, and inflation were left largely unchanged at the December 15-16 meeting. Unemployment is anticipated to fall to 4.7 per cent in 2016 while economic growth can be expected to rise 2.4 per cent. The FOMC expects expansion in economic activity at a moderate pace as well as further strengthening of the labor market with gradual adjustments in monetary policy. 

The way ahead

Now that the first rate hike is behind us, the markets are betting on the number of subsequent rate hikes in 2016. Markets broadly believe there will be 2 hikes in the next year. The Fed has assured the markets that the subsequent rate hikes will be gradual. The decision on future hikes will also be data dependent. This implies that The Fed will monitor inflation figure, which though has increased over time continues to remain way below the 2 per cent inflation target, before raising rates further. 

US CPI

The Fed will however have to ensure that it manages to stay ahead of the curve as the recovery continues. "To keep the economy moving along the growth path it is on ... we would like to avoid a situation where we have left so much (monetary) accommodation in place for so long we have to tighten abruptly.", Fed Chair Yellen noted.

Both unemployment rate and inflation figures are factors on which Fed’s rate decision is largely based. The Fed can be thus expected to decide on the timing as well as the size of future adjustments only after examining both realized and expected economic conditions.
The future rate hike decisions will be governed by the economic outlook formed by economic data. The FOMC expects economic conditions to evolve in a manner that will warrant gradual increases in rate. The Fed stated that it will proceed cautiously if incoming data in the coming months suggest inflation is not growing as expected. However this should not imply that Fed will want to see inflation to hike rates further. A health inflation figure will however help to boost the Fed’s conviction.

How many times will the Fed raise rates next year?

The FOMC said it will raise rates by 25 bps four times in 2016. Another four rate hikes can be expected in 2017. ‘Gradual’, for now thus stands for four rate hikes in 2016 and four in 2017. The question is whether the outlook will be strong enough to justify four hikes in 2016. 

The set of challenges which may continue to weigh on growth cannot be completely dismissed. A not so impressive global economic outlook is one of the main factors that might plague policy makers in 2016. The slowdown in emerging economies particularly China will continue to interrupt smooth growth process. The strong dollar is hurting US exporters negatively impacting trade. Economists do not see any immediate change in this situation. Also, oil price slump if not reversed will continue to keep prices in check. Core inflation will also suffer in case the dollar is appreciated any further. Wage growth may be hit by discouraged workers and involuntary part-time workers. Poor wage growth will hold back wage pressures, leading to lower inflation.

average hourly earnings

The poor performance of the manufacturing sector seems to be holding back growth and can be expected to weigh on growth in the immediate future. Manufacturing activity has been hurt by strong dollar, slowing foreign demand and of course the slump in oil prices. The Philadelphia Fed manufacturing index slipped into negative territory in December, falling to -5.9. This is the third negative reading in the past four months. The index for current new orders remained negative and fell to -9.5. Chicago Business Barometer also declined 7.5 Points to 48.7 in November. Sharp dip in new orders that fell to their lowest since March led to this massive decline. 

It thus so seems that the downside risks to rate projections are larger as compared to upside risks. The Fed therefore will likely not be able to raise rates four times in 2016. The broad belief in the market is that the Fed will hike rates twice next year.

Read also other related articles about what 2016 could bring for the markets:

Currencies
EUR USD Forecast 2016
GBP USD Forecast 2016
USD JPY Forecast 2016

Central Banks
ECB Forecast 2016
RBA Forecast 2016
PBoC Forecast 2016
FED Forecast 2016
BoE Forecast 2016
BoJ Forecast 2016
SNB Forecast 2016

Commodities
Gold Forecast 2016

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