FOMC Preview: Fed poised to raise rates, pace of subsequent hike to be ‘gradual'

Finally the day has arrived when the US Federal Reserve will likely raise interest rates for the first time since 2006 from its record low levels thereby exiting the zero interest rate regime. It will likely raise the target range of the Federal Funds Rate by 25 basis points to 0.25% - 0.50%, increasing the upper and lower limits of the effective funds rate. There are however some challenges that still remain. Oil prices have tanked post the OPEC’s decision to pump record volumes and high-yield debt has come under pressure. However, economists at Nomura believe the selloff will not impact Fed’s decision to hike rates.

The Fed’s tone is likely to remain dovish and Chair Yellen can be expected to adopt a cautious tone at the post meeting conference. With today’s rate hike, the Fed will become the only major central bank entering a hiking cycle as opposed to the ECB which has slashed rates further into the negative territory and BoE which has held rates steady.

Significant improvement in indicators

Markets have been speculating on the possibility of a December rate hike for some time now. The economic indicators were being closely watched to gauge the health of the economy. The Fed had declared earlier that the right time to raise interest rates would be when prices would stabilize significantly and the rise in employment rate would be satisfactory. 

The consumer price index released yesterday 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, dropping for the second straight month in November. The unemployment rate currently stands at 5 per cent. Growth recorded over the past few months signifies a robust labor market. The economy is seen gradually progressing towards full employment. Wage growth has been healthy as well. Average hourly earnings for all employees on private nonfarm payrolls increased by 4 cents to $25.25, following a 9-cent gain in October. Over the year, average hourly earnings increased by 2.3 per cent. These factors have raised the Fed's conviction that the economy is now prepared for the first rate hike in a decade. Fed Chair Yellen stressed that the risks of delaying the start of policy normalization outweigh those of moving.

FOMC members in support of a rate hike

The minutes of the Fed’s October meeting showed majority of U.S. central bankers in favour of a December liftoff. Atlanta Fed President Dennis Lockhart opined that the turmoil in the global financial markets that had caused the Fed to delay rate hike, has settled considerably. He also expects prices to further rise as the downward pressure from a strong dollar and low oil prices begin to fade. He is thus “comfortable with moving off zero”. Like most of his peers, the San Francisco Fed President John Williams also believed there exist a “strong case” for a rate hike. To back his inclination to hike rate he said, “the hiccup we saw in the couple labor reports has reversed” and “we’re seeing other signs the economy’s on a good track”. Cleveland Fed President Loretta Mester also believes that the economy is now strong enough to absorb a small degree of tightening.

Rate hike pace

Now that markets are almost certain the US central bank will hike rates at its meeting today, the focus has shifted to the pace of subsequent rate hikes. Central bankers have now expressed their concerns with respect to longer-term issues relevant to the pace of rate hikes following the first rate hike in a decade. The Fed is expected to stress today that the pace of future increases will be gradual, and increasingly, more data dependent. However, no one including the committee can say with certainty how slow "gradual" would be. Morgan Stanley's Ellen Zentner feels it would not be right for the Fed to leave markets' expectations for gradualism ‘right where they are.’ The Fed has said it will reassess conditions at every meeting and will discontinue rate hikes if so required.

Fed president Lockhart when questioned about the pace of rate hike said that the Fed will not hike rates in all its meetings. Fed has promised the interest rates to be gradual. The Fed might thus now opt for a "slow ... halting" effort to raise interest rates. "It is possible we will end up in period where the economy justifies (a rate hike at) every meeting, but I would define gradual as 'not every meeting”. He re-emphasized that subsequent rate hikes will be data dependent. He also said that the lower trend U.S. economic growth may imply the Fed's target "equilibrium" interest rate may be lower than that in the past.

The market estimates less than two hikes next year. Research team at Danske bank revised down their expectations for the number of Fed hikes. Danske bank now expects three hikes in 2016 as against four expected previously; while the expectation of number of hike in 2017 was left unchanged at four. The US activity data which recently showed some decline and the poor risk environment caused the bank to lower their expectation.