The probability of a rate hike at the US Federal Open Market Committee (FOMC)’s meeting on 14-15 June 2016 meeting rose to 28% from 13% a month ago. Bets on a rate increase at the 26-27 July 2016 policy meeting edged up to 61%, more than double the estimate from a month ago. If the economy picks up as expected and jobs continue to be generated, the US Federal Reserve (US Fed) should raise interest rates in the coming months, says a research note.
The Ecowrap report of State Bank of India (SBI) says, "Even after this, if the US Fed goes for a hike sooner than later it will be a decision purely based on non-macro factors, we believe. Thus a US Presidential elections in November may just prompt a rate hike now rather than later".
The markets are abuzz over a US Fed rate hike sometime in June. The reasons seem to be following. It seems there are two opposing viewpoints within Fed. In 2014, Stanley Fischer had argued strongly that there were indeed global spill overs that the FOMC needed to consider, but the US Fed should primarily focus on its own domestic objectives. This view has supposedly gained prominence in recent FOMC meetings and members have argued that the current level of US rates is still far below equilibrium and should be raised. Further, it was also argued that foreign influences may not be used as a reason to delay the rate increases.
"We, however, believe such a decision is unlikely," says SBI Ecowrap, adding, "The US President has openly advocated that UK stayed in the EU. The next Fed announcement falls a week before the Brexit referendum. A further slowdown in China’s economy also impacts the US economy through impact on asset prices through the capital account. Furthermore, China has condemned the US Defense Department's annual report on the Chinese military calling it deliberate distortion that has 'damaged' mutual trust. How should one connect these dots?"
Prior to the symbolic rate hike of 25 bps, the Fed decision was not conditional on factors outside the US. This changed by the end of the 2015, when the Fed acknowledged that they reviewed developments in all important areas of the world, but they were particularly focused on China. This remark was a marked departure from Fed stance and in the Minutes of the meeting of 18 May 2016, we find that British referendum on membership in the European Union and an unanticipated development associated with China's management of its exchange rate was point of concern, it says.
Basing a rate hike decision when labour market trends and GDP trends are at odds, cost of model risk is way too high. It appears that Philip Curve relationship has weakened post 2008. In addition, little has changed since 2008 in terms of macro data (see table below), but for unemployment rate, which again is difficult to digest for reasons cited above, SBI in the Ecowrap says.
"In light of this, there is a case to draw that the US Fed will adopt a long pause strategy before its next rate hike. The domestic environment does not hold any promise. Although the unemployment rate has fallen, the participation rate among the young population group is either stagnating or declining. To add to the woes, the participation rate among higher age groups is expected to rise by 1.6% per annum over the next eight years. The cumulative drag on labour productivity will moderate growth and therefore favours a rate hike with long gaps," the report added.