From the Ring. Looks like the Fed will hike rates

The US Federal Reserve watchers will carefully follow every data point between now and mid-December to find out whether the Fed will raise interest rates before the year end.

Two important data points have been released by the Fed recently which suggest reduced slack in the US economy.

A set of economic models shared by the Fed suggests that the output gap in the US might be closing after more than seven years.

Jobs card The US non-farm payroll (NFP) figures released by the Bureau of Labour Statistics (BLS) point strongly to the Fed hiking rates in December. While there were expectations of 150,000-240,000 job additions, the actual number was 271,000. The unemployment rate fell, pushing down the headline unemployment to 5 per cent. Interestingly, almost all jobs have been added in the 55-69 age group while workers aged 25-54 have actually lost 35,000 jobs!

According to Barclays’ chief US economist Michael Gapen , a closing output gap could lead to resource scarcity and potential upward pressure on inflation in the medium term.

There are other indicators pointing to a December rate hike. The Fed futures rates suggest a 68 per cent probability of a rate hike in December 2015 and this has risen from 35 per cent till as recently as October 27. Meanwhile, Chairperson Janet Yellen recently stated that the economy is “performing well”, adding that “it could be appropriate” to raise rates.

While its 2 per cent inflation target may not be met in a hurry, the Fed, nevertheless, is cognizant about it and may not stick to attaining the target before hiking rates.

Future inflation trajectory expectations also play an important role in the monetary policy framework of any central bank. The output gap data points to future inflation firming up which should give the Fed room to kick start rate normalisation in December this year.

Yields on two-year treasury securities, closely tied to expectations about the Fed policy, climbed to the highest level since April 2011 implying that rate hike is already priced in.

Volatility may be a hurdle The dollar has rallied strongly on rate hike expectations while gold slipped for precisely the same reason. Bearish flattening was noted, post-release of the NFP data.

The November data will be closely watched. What really stands between the Fed and rate hike in December is volatility.

A sharp climb in volatility driven by anxious markets in the run-up to the rate hike may just put the Fed on the back foot. The recent terrorist attacks in Paris have only increased nervousness.

Without doubt, the time is ripe for the Fed to hike rates beginning December, but if nervous markets were to come in its way, it will not be the first time the Fed is being held hostage by markets. If the Fed hikes rates, it will perhaps be the first rate hike by it in almost a decade and there are many who have never seen a rate hike in their careers as investment managers — the ‘rate hike rookies’.

The Janet Yellen-led US Fed is the lone central bank looking to increase interest rates in a world where most of their counterparts are still running easy monetary policy. The clear beneficiary of this hike would be dollar and dollar assets.

The author is CIO, Tata Asset Management. The views are personal

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