Interest Rate Eyed as Federal Reserve Meeting Looms


Markets are becoming increasingly skeptical of the Federal Reserve as the world's most important central bank heads into a meeting to decide on interest rates.

After several weeks of strong hints to the world that interest rates were going upwards, both economists and market participants are growing increasingly skeptical that the Fed will actually raise rates.

On June 16, the Federal Open Market Committee (FOMC) will meet to decide on whether to raise its Federal funds rate target. This interest rate is tied to both United States Treasury yields and interest rates on several consumer and business lending products, such as mortgages and corporate bonds.

In May, several Fed executives publicly spoke about an improving American economy and a robust labor market that demonstrated the country was ready for higher borrowing costs. Additionally, Fed officials noted that inflation and inflation expectations were on the rise, again necessitating an increase to U.S. Treasuries so that inflation does not spiral out of control.

Markets responded quickly. After pricing in just a 10% chance of a rate hike, probabilities rose to over 80%. More recently, however, markets have changed their mind and expectations of a rate hike in June have fallen to 20%. A July rate hike is seen as a 60% probability by markets.

Economist Responses

Several investment banks have also moderated their expectations of a rate hike in June. Citing poor jobs growth and a fall in the labor force participation rate, analysts told clients that the Federal Reserve could not justify increasing borrowing costs for businesses as they slow down on hiring Americans.

Paradoxically, stock markets in the United States have rallied on the news, as investors expect easier monetary policy and lower yields on Treasuries to force more investment in riskier instruments such as stocks.

Additionally, academic economists have become increasingly critical of the Federal Reserve's very public discussions about its next moves. Economist Tim Duy, whose blog "Fed Watch" is followed by many economists and financial professionals, has rightly predicted several Federal Reserve moves while also being increasingly critical of the central bank's failure to focus on the persistently weak labor market that, while better than in 2009, remains below its strength before the financial crisis.

Now Duy notes that inflation uncertainty is driving an "inflation problem" for Fed chief Janet Yellen. Noting inflation expectations have been driven lower and to their lowest point since the surveys began, Duy believes the Fed should soften its recent statements that inflation is actually strengthening. The Fed "should change the language" in their statement on inflation, he wrote, "but I don't think the[y] will."

The problem, Duy argues, is not economic but one of credibility, as the Fed would need to admit its recent statements on inflation has been wrong.

"The problem is that if the Fed acknowledges serious concern about declining inflation expectations, they have to deal with this line from the FOMC statement: 'The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate ... [but it is] expected to prevail in the longer run."

Duy believes this positions the Fed in a hawkish monetary position, where they expect inflation and inflation expectations to continue to rise. Recently, that thesis has been bolstered by increasing energy costs, but labor slack and other economic worries are expected to offset higher oil prices.

Therefore, Duy argues, inflation expectations are expected to fall but the Fed's recent position precludes them from admitting that. "It makes no sense to show concern with the possibility of unanchored inflation expectations to the downside while at the same time stating that you anticipate the next policy action will be a hike," he writes.