Will the Fed raise or reserve?

With the Federal Reserve due to start its September meeting tomorrow, markets are turning their attention to Thursday's announcement in anticipation of massive volatility.

Federal Reserve
Source: Bloomberg

The decision of whether the 12-member FOMC will raise interest rates for the first time since 2006 has been one of the biggest topics within the markets since the Fed ended QE3 back in October 2014.

The recent selloff in US indices and earlier strength of the dollar is no doubt significantly influenced by the expected tightening of monetary policy and thus both those markets are expected to be heavily impacted on Thursday.

Since ending QE in October, the question of when the Fed will finally begin to raise rates has been absolutely key to market sentiment, with many believing this would spark another major selloff for global indices. Within this discussion, September has always been viewed as a highly likely time for rates to finally lift-off and with the US jobs market showing great strides, the reasons against a hike have gradually fallen away.

The futures market allows us to track how market sentiment has changed over time and what the perceived likeliness of a rate hike will be for each meeting. On 7 August, expectations of a September rate rise peaked at 54%, yet this has fallen dramatically to the 28% seen today. Instead, the highest rated month is December which has an associated 48.9% chance that rates will see that first hike.

What has changed between 7 August and today to alter this view? Well, 7 August was the day of the US jobs report and for once it was largely uneventful, with little for the Fed to worry about. However, with the crash in Chinese financial markets, China has leaned on to its Western counterparts to bring about fresh anxiety that we could be at the beginning of another crash. Meanwhile, the slowdown in the Chinese economy means that demand for imports plummeted, bringing commodity prices with them. The plummeting price oil commodities has subsequently brought inflation lower globally and certainly for a country like the US, which has seen a huge rise in oil exploration, this could in turn impact employment and growth figures.

With stock markets and inflation falling, alongside a possible fallout in terms of jobs and growth, this doesn’t seem like an ideal time to act for the notoriously cautious Fed.

Apart from the actual rate decision, there are a number of things to watch out for on Thursday’s decision. Inflation and growth projections will be crucial to understanding whether the committee sees disinflation persisting which therefore has knock-on effects for future rate rise expectations. In July, the Fed noted that rates would rise once ‘it has seen some further improvement in the labour market and is reasonably confident that inflation will move back to its two percent objective over the medium-term.’ With the inflation outlook showing little signs of improvement, yet a jobs market is stable and certainly appears to be appropriately positioned for a rate hike.

The statement and Q&A session provides markets with further clues as to whether the stance of the committee has changed at all. Often the market will react initially to the headline announcement (interest rate decision) and subsequently respond to any changes in language within the statement. Thus be aware that a secondary wave of sentiment is likely to follow any initial move in the markets following the announcement.

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