Interest Rate Hike in 2015 Likely, Despite Disinflation Fears

The Federal Reserve is likely to raise short-term interest rates for U.S. Treasuries, despite fears such a move could hurt equities and kick start a recession.

Federal Reserve Chairwoman Janet Yellen again reiterated the central bank’s cautionary position on interest rates, suggesting that the Fed will begin to raise rates gradually later in 2015. “With continued improvement in economic conditions, an increase in the target range for that rate may well be warranted later this year,” she said on Friday at a meeting in San Francisco.

The Federal Reserve is likely to raise short-term interest rates for U.S. Treasuries, despite fears such a move could hurt equities and kick start a recession.

Federal Reserve Chairwoman Janet Yellen again reiterated the central bank’s cautionary position on interest rates, suggesting that the Fed will begin to raise rates gradually later in 2015. “With continued improvement in economic conditions, an increase in the target range for that rate may well be warranted later this year,” she said on Friday at a meeting in San Francisco.

Although Yellen continues to signal to the market that an interest rate hike is coming, she again stressed that the Fed’s decision will be data-dependent and will incorporate a number of different indicators, making it impossible to predict fully. “Of course, the timing of the first increase in the Federal Funds rate and its subsequent path will be determined by the Committee in light of incoming data on labor market conditions, inflation, and other aspects of the current expansion,” she added.

Disinflation Dismissed

In early 2014, most market participants expected an interest rate hike within the following 24 months, and policy statements from the Federal Reserve indicated a chance of this at the time. However, a faster and accelerating trend of lower inflation rates towards the end of the year made the Fed pause that position, noting that inflationary pressures were evaporating.

Going into 2015, many investment banks and economists suggested that cheap oil, weak wage growth, and falling price growth. The Consumer Price Index for urban consumers (CPI-U) showed particular weakness at the end of 2014, falling 0.3% in December, 0.7% in January, and rising 0.2% in February on a seasonally adjusted basis. The CPI also fell for four of the last six months in 2014 due in part to cheaper oil, essentially forcing the Fed to postpone its interest rate hikes.

However, in her most recent statement, Janet Yellen suggested low inflation growth might not justify waiting on an interest rate hike any further in an uncharacteristically hawkish statement. “I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective,” she said, hinting that an interest rate hike could happen before headline inflation increases to 2%.

Yellen added she holds this position because much of the fall in inflation is not demand driven but a side effect of the increase in oil supplies. “Much of this weakness [in inflation growth] stems from the sharp decline in the price of oil and other one-time factors that, in the FOMC’s judgment, are likely to have only a transitory negative effect on inflation, provided that inflation expectations remain well anchored,” she said.

Analysts at two investment banks have published notes urging caution after Yellen’s speech, suggesting that a pull of investment from U.S. stocks could come if the Fed raises rates later in 2015. A recent note from Nomura Securities said wage growth is likely to accelerate in March, and payrolls will increase at a “solid pace” for the month. That, in turn, could embolden the Fed to raise rates in the next few months.