Ongoing Angst over Rate Hike Prospects

If the Fed were to forgo a rate hike on Thursday, it may lose some ability to keep future increases as gradual as the bond market would like.

As the Federal Reserve prepares to raise interest rates for the first time since 2006, almost all the talk of a potential policy misstep has centered on the peril of hiking too soon.

The bigger concern is that the Fed may wait too long, say Thomas Lam at RHB Securities Singapore Pte. Ltd and David Glocke at Vanguard Group Inc. A decision to keep the overnight rate near zero on Sept. 17 may wind up jolting debt markets more than actually raising it, said Lam, who according to Bloomberg was the fourth-most-accurate forecaster of the U.S. economy last quarter.

The worry is that by holding its target at crisis-period levels too long, the Fed may fail to get ahead of a strengthening economy. That would push up yields as traders anticipate that policy makers will have to adopt a more aggressive approach to lifting interest rates than the gradual path Fed Chairman Janet Yellen has stressed.

“They may get behind the curve on the economy and possibly on financial stability and lose credibility in the markets with being able to follow a gradual rate path higher,” Lam said from Singapore. “That means you are going to be affecting the whole range of rates down the road, and the economy is more affected by longer-term rates.”

The Federal Open Market Committee (FOMC) has held its target in a range of zero to 0.25 percent since December 2008 to support the economy. Fed funds futures show traders see a 28 percent chance of an increase this week, down from 48 percent a month ago, according to data compiled by Bloomberg. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.

The probability has declined along with signs of a slowdown in China and last month’s rout in global stocks. Fed officials are balancing the recent market turmoil with signs of a strengthening U.S. economy: The nation’s jobless rate fell to 5.1 percent in August, the lowest since April 2008.

 

Gradual Rate Increase Likely

“If the Fed waits too long, all of a sudden it is going to catch up to them one day and they are going to have to go faster,” said Glocke at Valley Forge, Pennsylvania-based Vanguard, which manages $3.4 trillion. “I’d rather see them get the ball rolling. Start us off and give us a nice dovish statement afterwards.”

Interest-rate markets are signaling that even with the lack of consensus on when the tightening will begin, most investors are buying into the Fed’s gradual message.

Forwards imply that 10-year Treasury yields, now at about 2.25 percent, will stay below 3 percent for the next half-decade. Money-market derivative traders see the funds rate sill below 1 percent by the end of next year.

Fed Vice Chairman Stanley Fischer last year, before taking his current position, offered remarks that could lend support for those expecting a rate boost this week. The situation is always unclear and monetary policy takes time to affect the economy, he said at the time.

“It’s not feasible for the FOMC to get the timing of the start absolutely right,” said Lam, who predicts the Fed will lift rates this week.

“But ultimately the Fed should avoid the cost of potentially surprising on the path, by surprising on the timing now,” he said. “That’s the least costly option.”

 

--With assistance from Rich Miller in Washington and Paul Cox in New York.

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