The biggest interest rate policy announcement in years is finally upon us.
At 2:00 p.m. ET on Thursday, the Federal Reserve will announce the outcome of its two-day meeting, and they will reveal whether or not they chose to raise interest rates for the first time in nearly a decade.
The Fed has held its benchmark lending rate near zero since 2008 to boost spending and economic growth following the financial crisis and hasn’t actually raised rates since July 2006.
Last October, when the Fed announced the end of its bond-buying program, or quantitative easing it was the first major sign that the era of super accommodative monetary policy was ending. On Thursday, this era may finally come to an end.
This May, Federal Reserve chair Yellen gave her first real indication that 2015 was on the table for higher rates.
Yellen said in a speech at Providence, Rhode Island:
“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 target and begin the process of normalizing monetary policy
. To support taking this step, however, I will need to see continued improvement in labour market conditions, and I will need to be reasonably confident that inflation will move back to 2 per cent over the medium term.”
This statement captured the essence of the Fed’s dual mandate: Full employment and price stability which it defines as inflation running at about 2%.
How has the data evolved since then?
Incoming economic data have been mixed, but undeniably point towards a healthy economy. Gross Domestic Product, the economy’s bellwether, was revised higher for the first and second quarters.
On the labour market, Wells Fargo’s Sam Bullard summed up in a recent note to clients: “With the exception of wage growth, the Fed appears to be pleased with the progress that has been made in the U.S. labour market. Nonfarm hiring has been consistently solid and the unemployment rate is near most Fed officials’ estimate of full employment.”
However, inflation remains the complicated, out-of-reach leg of the Fed’s mandate.
The recent drop in commodity prices, particularly in oil, has put pressure on prices. On Wednesday, the consumer price index fell month-over-month for the first time this year, and the labour department blamed low gas prices again.
Core personal consumption expenditures — the Fed’s preferred inflation measure — is at 1.2% year-on-year.
And then there’s the strong dollar. Last week, the labour department reported that import prices fell 1.8% in August from July, primarily driven by cheaper fuel, as well as a stronger domestic currency that makes imports cheaper.
However, Fed vice chair Stanley Fischer reiterated in August that the Fed expects inflation to move higher, and it does not need a perfect 2% print to raise rates.
With the labour market near full employment, and confidence that inflation will reach 2%, there’s one other thing that complicates the Fed’s decision.
The third mandate
Financial stability — of the biggest markets and institutions — is the Fed’s unofficial third mandate. And after the plunge in stocks last month, the Fed is in a position where this must factor in to its decision.
Many things were fingered for the sell off, including fears about upcoming higher borrowing costs.
Deutsche Bank’s Joe LaVorgna abandoned his call for a September rate hike, noting that the Fed would not want to surprise markets.
The benchmark for so-called market expectations lies in Fed funds futures. On Wednesday, Fed fund futures trading reflected a 28% probability of a hike in September.
Clearly, this market is not counting on an imminent rate hike, and the Fed may take its cue from here. We highlighted a note from Morgan Stanley’s Matthew Hornbach which pointed to the so-called ‘Bond Market Massacre‘ in 1994, when the Fed raised rates despite futures reflecting only a 22% probability of liftoff.
Meanwhile, markets are pricing in a 63% chance the Fed waits until December.
What to expect on Thursday
Morgan Stanley strategists came up with four phrases that sum their thoughts on the most likely scenarios.
- A Hawkish Pass, where the Fed does not hike, but signals that October or December are on the table.
- A Hawkish Hike, where the Fed even acknowledges that it could have gone in June.
- A Dovish Pass, where there’s no hike, and the Fed blames the recent tightening in financial conditions and low inflation.
- And, Dovish Hike, where the Fed raises rates with the assurance that future hikes will be gradual.
If anything, this depicts the uncertainty with which folks are approaching Thursday’s meeting: these are completely made-up, new terms being used to describe the most anticipated Fed meeting in years. Everything is on the table.
The Fed’s announcement will also include updated Fed projections on the US economy, including forecasts for GDP and inflation.
After the 2:00 p.m. ET policy announcement, Fed chair Janet Yellen will hold a 2:30 p.m. ET press conference to discuss whatever it is the Fed decides.
Until then, we wait.
NOW WATCH: KRUGMAN: Wall Street Is Wrong, Janet Yellen Is Making Exactly The Right Move On Inflation
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