'There is no question' the US economy can cope with a rate rise this week

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There is no question the US domestic economy is solid enough to cope with a modest tweak in interest rates, and in what will be a very close call, the US FOMC are likely to deliver it this week.

That’s the house view of Tom Kenny and Dylan Eades, members of ANZ’s economics team, who believe the US Federal Reserve will look past recent financial market volatility and concerns about the growth outlook for emerging markets and raise interest rates for the first time since June 2006 later this week.

While the pair admit that the FOMC could err on the side of caution given heightened global market volatility, something will weigh on FOMC policymakers’ monetary policy deliberations come Wednesday and Thursday this week – with domestic economic conditions in the US “robust”, the grounds for a rate increase are in place.

Despite US economic growth being solid rather than spectacular, Kenny and Eades suggest this is largely due to soft external demand and recent US dollar strength. However, with the FOMC’s full employment mandate now satisfied, having seen unemployment fall to a fresh seven-year low of 5.1% in August, something that will boost inflation expectations once transitory US dollar strength and oil-led deflationary pressures pass, they believe the Fed will be confident enough to begin policy normalisation later in the week.

Here’s the pair on the impending rate increase, and how the FOMC may look to counter any spike in volatility that may arise from the event:

“In sum, there is no question the US domestic economy is solid enough to cope with a modest tweak in interest rates from zero. However, the spike in asset volatility has raised concerns about financial stability and the economic outlook for emerging markets. The Fed’s past tightening cycles don’t provide much guidance as to how the Fed might respond to this higher volatility and tightening in financial conditions. Despite previous episodes suggesting Fed hikes won’t add to volatility, there is no guarantee this time. However, the Fed could counter any possible volatility of a rate hike by simultaneously lowering its dot plot (lower slope and end point).”

In other words, while the decision will surprise markets which currently see the likelihood of a rate increase in September at less than 30%, the FOMC may counter this shock by greatly reducing expectations for speed and scale of monetary policy tightening in the years ahead by lowering their forecast pathway for the Fed funds rate.

The FOMC will announce its September monetary policy decision at 4am AEST on Friday. Updated economic forecasts, along with a press conference from Fed chair Janet Yellen, are also scheduled.

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