The FOMC Awakens

The recent meeting by the FOMC ended, no much surprise there, with the historic rate hike. But because the FOMC has been preparing us for the hike for such a long time, the reaction in the market was quiet subdue with a modest gain for the U.S. dollar against major currencies. Is this the right time to raise rates?

The simple answer is no. The decision is made in times of low inflation and based on the Fed’s own outlook the core PCE is expected to reach only 1.6% — lower than in the September outlook. The labor market is expected to keep progressing, although growth in wages is still low and could be better and real unemployment remains elevated.

The Fed is worried, however, that inflation may start to erupt next year, which will force the Fed to raise rates at a fast pace. In such a scenario, the Fed is concerned of causing a recession. This could be an issue, but given the slow rise in wages and low prices of energy and other commodities, it seems a less likely occurrence.

In any case, the Fed didn’t revise its median outlook in the dot plot for the Fund’s rate for 2016: 1.375%. Only for 2017-2018 there were modest downward revisions. So the Fed still expects raising rates four time over the next 12 months. But the market is less convinced. Based on the implied probabilities in the bonds market, the market estimates the Fed’s fund rate will reach 0.9% by the end of 2016 – or two hikes. This seems a more plausible scenario than the Fed raising rates four times at this point in time.

It’s also important to notice that given the high amount of cash floating in the markets, the Fed won’t be able to control rates by reducing or expanding the supply of money – as it used to. The QE programs made it impossible. So the Fed will have to resort to paying banks 0.5% for keeping money at the Fed and receiving 0.25% for lending money – this should bring the Fed’s fund rate to the 0.25-0.5% range.

What’s next?

The next rate hike isn’t expected anytime soon, and it will be important to notice how the market adjusts to this new regime. For the most part, a 0.25% bump won’t make much of difference. It’s the matter of how the Fed will move forward.

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