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How the Fed Is Managing This Market

Daniel Cross

Mar 10, 2016

In 2015, investors waited nearly the entire year – all the way up to December – for the long-awaited Fed interest rate hike that had been discussed as a possibility even before the year began. Finally, on December 16, the key rate was increased by 0.25%, marking the first hike in nearly 10 years and setting the stage for what most investors thought would be a string of increases over the next 12 months until an optimal interest rate was achieved along with steady inflation.

In practice though, the rate hike seemed almost forced, considering the very evident lack of a key element the Fed had said they needed to see first: inflation. With inflation still anemic, the Fed raised rates anyways, sending the markets temporarily higher before dropping again as investors realized that the overall positive fundamentals for an increase in rates just weren’t there.

What Is the Fed thinking Now?

After a disappointing slew of economic data, the Fed reversed its viewpoint on the economy just a month later, issuing a statement that actually painted deflation as a real possibility. This left many investors wondering exactly how the Fed would respond to this new threat.

However, inflation data in January showed a sharp spike to 1.4% – much closer to the 2% threshold the Fed had been waiting for and a good sign that inflation was picking up as originally anticipated. The National Association for Business Economics (NABE) revealed that 80% of economists believe that there will be another Fed interest rate hike this year, but investors are more skeptical given the Fed’s recent track record of inconsistency and an overall malaise in the global economy.

The continued weakness in global commodity prices is alarming as well. Commodities tend to do well when inflation rises, but with oil at multiyear lows and bumper crops in soft commodities keeping prices low, it doesn’t seem to be pointing to an inflation recovery.

One indicator investors are keeping an eye on is CME group’s FedWatch tool which predicts the possibility of a Fed rate hike. December looks like the most likely candidate right now with an estimated 70% hike to 0.50%. The possibility increases every month beginning with an 18% likelihood in April.

Another hike in December makes the most sense. It gives the economy plenty of time to build up inflation while keeping to the Fed’s goal of slowly raising rates to avoid startling the markets and keep the increase gradual and consistent.

The Bottom Line

The Fed’s message might have been a little off point in the past few months, but several key issues need to be resolved before investors can be confident that a rate hike will happen again. First, commodities need to come off their lows. Second, inflation figures, even if they fall short of 2%, need to show steady improvement with the probability of continuing to rise. Finally, unemployment should stay low at the 5% range.

Once these three key indicators align, we should see more confident and accurate statements from the Fed regarding another rate hike. One thing that’s still unclear is how long the rate hike talk will go on and how many increases we’ll see before the Fed officially announces that it has reached its goal. The original 12-month timeline for completing the process is looking like it could be extended by at least twice that time.