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Fed ends low rate era, future hikes gradual & data dependent

Discussion in 'Fundamental Analysis' started by FXStreet_Team, Dec 17, 2015.

  1. FXStreet_Team

    FXStreet_Team Well-Known Member Trader

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    FXStreet (Mumbai) - Ending the zero interest rate regime that the US Federal Reserve had held steady for almost a decade, the Fed finally raised increased the Fed funds target range by +25bps to 0.25%-0.5%. The raise was in line with broad market expectations. The increase in rate can be justified considering the significant improvements seen in the economy.

    Unemployment rates have held steady at 5 per cent implying the strengthening of the labor market. The latest inflation report also showed a rise in inflation from 0.2 to 0.5 per cent month on month in November. These figures put to rest concerns whether the economy was prepared to embrace higher borrowing costs. Fed Chair Yellen noted "With the economy performing well and expected to continue to do so, the committee judges that a modest increase in the federal funds rate is appropriate."

    The Fed expects the recovery process to continue. Unemployment is anticipated to fall to 4.7 per cent in 2016 while economic growth can be expected to rise 2.4 per cent.

    Rate hikes to be gradual

    The rate of subsequent rate hike, Yellen said would be gradual and dependent on incoming economic data. Before taking decision of subsequent hikes the Fed would monitor inflation figure, which though has increased over time continues to remain way below the 2 per cent inflation target.

    It is evident that the Committee expects expansion in economic activity at a moderate pace as well as further strengthening of the labor market with gradual adjustments in monetary policy. The Committee also expects economic conditions to evolve in a manner that will warrant gradual increases in rate.

    Yellen clarified that the pace of the rate hikes would definitely be slow but at the Fed will have to ensure that it stays ahead of the curve as the recovery continues. "To keep the economy moving along the growth path it is on ... we would like to avoid a situation where we have left so much (monetary) accommodation in place for so long we have to tighten abruptly.", she noted.

    The FOMC will raise rates by 25 bps four times in 2016. Another four rate hikes can be expected in 2017. As of now ‘gradual’ stands for four rate hikes in 2016 and four in 2017.

    Rate hike to be data dependent

    The Fed has stressed on numerous occasions that unemployment rate and inflation figures are factors on which its rate decision is largely based. Going forward, the Fed said it will decide on the timing as well as the size of future adjustments only after examining both realized and expected economic conditions. Thus the federal funds rate decision will depend on the economic outlook formed by economic data.

    What might stop the Fed from raising rates four times?

    The pace of recovery has undoubtedly gathered momentum. However, the set of challenges still remain, which may weigh on growth. A not so impressive global economic outlook cannot be ignored completely. The slowdown in emerging economies particularly China will continue to interrupt smooth growth process. To add to it, the strong dollar is hurting US exporters negatively impacting trade. Oil price has further slumped since OPEC’s 4th December decision to pump record volumes, disregarding glut worries. If this is not reversed, oil prices will continue to weigh on prices. Core inflation will also suffer in case the dollar is appreciated any further. Wage growth may suffer as discouraged workers and involuntary part-time workers continue to hold back wage pressures, leading to lower inflation.

    Going by the current economic conditions it seems that the downside risks to rate projections are larger as compared to upside risks. The Fed therefore will likely not be able to raise rates four times in 2016. The broad belief in the market is that the Fed will hike rates twice next year.
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