Here are the 2 questions Fed members need to ask themselves this week

This week is all about the Fed.

On Thursday, the Federal Reserve will announce its most anticipated monetary policy decision in years. Currently, markets aren’t pricing in a move from the Fed, which hasn’t raised interest rates since July 2006.

But many economists on Wall Street think the US economy is currently strong enough to warrant a rate hike and consequently expect the Fed to act on this basis.

In a note to clients on Friday afternoon, Stephen Stanley, chief economist at Amherst Pierpont — among those that think the Fed will raise rates this week — wrote that in weighing the decision to raise rates or not, Fed members need only ask themselves two questions:

  1. Is the market volatility severe enough to justify putting off a rate hike where there would otherwise be a case for one?
  2. What does the Fed get by putting off rate hikes for at least another 5 weeks?

Stanley writes in response to the first question that, “In my opinion, the answer to that is no. Over the past few weeks, volatility has been above normal but has not risen to the level that would be destabilizing for the economy, and marginal weakness in China and/or other emerging markets will not have a significant enough impact on U.S. economic growth to change the calculus.”

And so while the impact of a volatile stock market may be weighing on things like consumer confidence, Stanley doesn’t think these ultimately superficial concerns about the economy are anywhere near manifesting themselves in a way that changes the Fed’s view of the economy.

To the second question, Stanley writes: “In my view, the answer to that question is nothing. Volatility is not going to die down as long as the markets are fixated on the prospects of Fed liftoff. In fact, the longer things drag out, the worse the volatility is likely to get. Thus, despite being in a minority, I believe that the FOMC will raise rates this week.”

These comments, overall, are not dissimilar to what Peter Tchir at Brean Capital had to say a few weeks ago when he argued that the market volatility in the end of the August is exactly what the Fed needed to raise rates.

Basically the thinking here is that while vague handwaves are made towards things like “China” and “global growth” when looking for an exact reason why the stock market has been so rocky, ultimately the uncertainty created by the Fed is at the root of this.

If the Fed funds rate is the baseline against which all other interest rates are measured, and if this rate is on the cusp of being changed for the first time in almost a decade, then yes, markets are going to be unstable ahead of that move.

And so what Stanley and others are saying is that the longer the Fed does nothing, the longer it creates the exact circumstances that many think will prevent it from raising rates.

This, of course, then puts the Fed in a circular trap wherein it won’t ever raise rates. (Which, we would note, some people actually think will happen.)

And while this week’s commentary ahead of Thursday’s meeting is likely to center on the question of “will they or won’t they,” what the Fed does further down the line is just as, if not more, important than what happens this week. On this front, Stanley thinks the Fed would be very clear that this rate hike is not the first in a series of aggressive measures.

In fact, it would probably be the opposite.

Here’s Stanley:

A rate hike would likely be accompanied by signals intended to soften the blow. First, the statement will no doubt repeat and Chair Yellen will emphasise in her press conference that the trajectory of rate hikes will be quite gradual. In addition, a new round of Fed “dots” will probably be lowered somewhat again. Conversely, if the Fed stands pat this week, it may signal that it is getting quite close to a move, though another instance of Lucy pulling the football before Charlie Brown can kick it will only add to the questions about the credibility of the Fed’s forward guidance dictums.

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