The Federal Reserve looks set to raise interest rates on Wednesday.
The Fed has kept interest rates pegged in a range of 0%-0.25% since December 16, 2008 and in its 2:00 p.m. ET policy statement is expected to bring rates up to a corridor of 0.25%-0.50%. (Some other stuff will happen, too.)
But in a note to clients on Tuesday, economists at BNP Paribas looked at what it views as the three most likely scenarios that follow a Fed rate hike.
And on balance, the firm expects that things will probably go wrong.
Here’s BNP (emphasis ours):
In our view, the risk that things go wrong is greater than things going well. While our baseline scenario is for a risk-weighted benign outlook, we see the risks as two-sided: the Fed could hike more quickly in response to inflation that wakes up after a long nap, or stop raising rates all together in order to digest a rockier outlook (more likely in our book). Given the lack of ammunition for the Fed to ease (either through rates, more QE or lowering IOER), the Fed is likely to find a greater willingness to pause and not overshoot on rates than it would if rates were higher. This implies that if/when we do hit a bump in the road (recession-worthy or otherwise) the Fed is likely to quickly run out of ammunition and resort to another round of QE (QE4).
The core disagreement among economists ahead of the Fed’s expected rate hike has basically been:
- Does the Fed want to raise rates because the labour market has near an inflection point at which wages — and as a result inflation — begin to take off?
- Or does the Fed want to raise rates just so it has room to manoeuvre when the economy hits another snag?
And BNP basically argues that it’s more likely that whether or not the Fed intends to, hindsight will reveal that this rate hike likely satisfied an answer to the second question more than the first.
In its note BNP outlined three basic scenarios for how things play out after the Fed hikes rates.
Either the whole thing is just mis-timed with inflation either not rising at all or rising faster than the Fed forecast, the markets “run for the hills” as something bad happens in the economy after the Fed moves, or things are just fine.
This final “Goldilocks” scenario is, in BNP’s view, only about a 30% possibility.
And so with BNP assigning a 70% likelihood to the possibility that the Fed is making or has already made a mistake by waiting until Wednesday’s meeting to raise rates, it’s fair to say that the backlash cycle has already begun.