Federal Reserve officials trying to decide when to raiseinterest rates for the first time in a decade may want to avoidwaiting until December to make their move.

The reason: Treasury-market liquidity has a clear pattern ofthinning out at year-end, potentially exacerbating volatility inreaction to an increase in the Fed's benchmark rate. A sharp risein yields could hurt the economy and complicate liftoff.

These concerns won't be a deal-breaker if economic data supporta rate rise in December and not sooner, economists say. Still, theycould make officials look more favorably upon a September orOctober start. Fed Chair Janet Yellen has said liftoff will beappropriate this year if the economy evolves as expected.

“Oursense is the Fed would love to raise in September,” said LoriHeinel, chief portfolio strategist Boston-based State Street Corp.,which manages $2.45 trillion. “The longer they wait, other thingsstart to become considerations, including concerns about year-endliquidity and the volatility that may introduce.”

The Fed has said it will tighten if the labor market continuesto improve and it's “reasonably confident” inflation will move backup toward its 2 percent objective. While the central bank isnearing its target for full unemployment—the jobless rate fell to aseven-year low of 5.3 percent in June—inflation has lingered belowthe goal for three years.

Some 76 percent of economists expect the first rate rise at theFederal Open Market Committee's (FOMC's) September meeting, aBloomberg survey taken July 2-8 shows. Just 6 percent expect achange in October—a meeting that isn't accompanied by a pressconference—and 10 percent expect a December move.

Yellen holds press conferences after every other meeting, andeconomists say she would prefer to move on raising rates at one ofthose meetings, although she has said every gathering is live. Just4 percent of economists in the survey predicted a move at nextweek's meeting.

December Volatiliy in Treasuries Market

Turnover in Treasuries has historically dipped during the finalweeks of the year. The volume traded through ICAP Plc, the largestinter-dealer broker of U.S. government debt, averaged $288 billiona day back through 2010. In contrast, the average over the finaltwo trading weeks of each year from 2010 through 2014 was $137billion.

Liquidity in Treasuries tends to dry up in December wheninvestors ranging from pension funds to banks buy governmentsecurities and hang onto them to make their holdings look safer foryear-end reporting requirements. Trading volume also declines asdealers leave their desks for the holidays.

Thinner year-end markets translate into larger movements inprices. Volatility on options that expire in a few months ontwo-year U.S. rates, whose short-term maturity makes them mostaffected by changes in Fed policy, has moved higher during thefinal month of recent years. Volatility on these three-monthoptions rose 30 percent in December from the prior month, and 50percent in the final month of 2013.

Officials discussed the risk of increased volatility at liftoffin April, minutes of the meeting show. They discussed the so-calledtaper tantrum in 2013, when Treasury yields jumped afterthen-Chairman Ben S. Bernanke said the Fed might soon startreducing its bond purchases.

A steep rise in yields might be a bigger drag on the economythan officials would like to see. Yellen, concerned that a sharprate increase could derail the recovery, last week said she prefersto “tighten in a prudent and gradual manner.”

In addition, the final days of the last two quarters have seenincreased volatility in repurchase agreements, the money-marketinstrument the Fed will deploy to tighten policy, due to banksstepping back from the market to manage their balance sheets. Thatmay make it tougher to achieve a smooth liftoff.

When the Fed decides to raise rates, it will be using a new setof tools that will allow it to navigate the trillions of dollars inexcess reserves that it created in the course of three rounds oflarge-scale asset purchases.

“This is an unprecedented rate increase, the mechanisms forwhich are relatively untested, and they will probably want torefrain from doing that at year-end,” said Gennadiy Goldberg, U.S.strategist at TD Securities USA LLC in New York.

Fed to Set Interest Rate Range

The Fed has said it will seek to keep the federal funds rate,which represents the cost of reserves that banks borrow and lend inthe overnight market, in a 25 basis-point range.

The top end of the range will be determined by the interestrates the Fed pays banks on excess reserves, currently 25 basispoints, or a quarter of a percentage point.

The bottom end will be set by the Fed's overnight reverserepurchase agreement program, currently at 0.05 percent. In thoseagreements, the Fed borrows cash from money-market counterpartiesand posts bonds from its portfolio as collateral. The next day, theFed returns the cash plus interest and gets its bonds back.

Economists said that if the Fed wants to be confident ofachieving a smooth liftoff, and wants to see that their reverserepurchase tool is working as intended, it makes sense to pick aperiod when liquidity won't be questionable.

The Dec. 15-16 timing of the final FOMC meeting of the year, inthe middle of America's most important retail sales season, mayalso be a consideration for officials concerned that a rateincrease could drive share prices lower and harm consumerconfidence.

“A considerable hit to consumer confidence during the keyshopping season of the year—that could substantially reverberatethroughout the economy,” Goldberg said. “That's something the Fedis keen to avoid.”

On the other hand, the Fed has shown a willingness to overlooktechnical volatility in the past: Tapering of the Fed's bond-buyingcampaign was announced in December 2013. It also raised rates inDecember 2004 and December 2005, though that tightening cycle gotunder way in June 2004, and officials weren't relying on overnightrepos to steer fed funds higher.

While December is an imperfect choice, policy makers will opt tomove then to avoid pushing liftoff further into the future,economists at BNP Paribas wrote in a July 9 note.

“December is not ideal for liftoff, given likely thin year-endliquidity,” they wrote. “It's better than waiting until March. It'snow our central case.” Laura Rosner, U.S. economist at BNP Paribasin New York, said she didn't view the Jan. 26-27 FOMC as likely fora rate move because it lacked a scheduled press conference.

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