The Federal Reserve Open Market Committee meets next week to decide whether to raise the Federal Funds rate. The inter-bank lending rate is the benchmark interest rate and has immediate and wide-ranging implications globally. The current rate is practically zero and last saw an increase a decade ago. An increase now would signal the completion of a turnaround in the U.S. economy and confidence in its bounce back from the "Great Recession" now eight years ago. This hike has been "imminent" for over a year now and I've been dismissing those that have predicted a hike at every meeting since then. A rate hike this meeting will also have implications for American allies and "non-allies."
Any hike in the Federal Funds Rate would translate into higher borrowing costs for consumers and businesses. This would mean lower margins for firms and a decrease in spending by consumers. Bond markets will also be hit hard as bond yields will increase to accommodate the greater demands of fixed-income investors. So what's the positive effect of an interest rate hike, if any?
In the United States, the first major effect of a rate hike will be a stronger dollar, despite the fact that most investors may have already priced in a period of rate hikes going forward. A stronger dollar will mean cheaper imports and cheaper commodity prices like gas and orange juice for consumers. The flipside of a strong dollar is that international firms that rely on foreign earnings will see these earnings decrease. Commodity traders and exporters will find fewer customers for their goods. This includes foreign countries that export commodities, such as Russia, the world's second largest oil exporter. As commodity-rich countries see growth stagnate, so too will the U.S. economy. This "cooling-off" of the economy is what is meant to happen, despite nominal GDP growth being at record lows for a period of tightening monetary policy.
As the dollar grows stronger, commodity prices continue to decrease which in turn is meant to cause a slowing of inflation. Although the economy at present is experiencing inflation far less than the targeted 2 percent, the employment market appears to have reached "full-employment," that is if you buy into last week's non-farm payroll numbers. This means that anyone currently looking for a job in the United States has already found one. The caveat being, those that stopped looking after seven years of recession, aren't counted anymore. This number, the employment participation rate, continues to be at near 40-year lows.
What will be different about this period of rate hikes, if an actual "period" takes place as opposed to a one-off hike? This question is pertinent only because we are deep in unchartered territory. There has never been a rate hike from 0 percent to something higher and thus there has never been a reversion to 0 percent. In other words, no one knows what's going to happen. Here's my prediction:
According to the Fed Funds Futures markets, investors forsee at least four rate hikes of 25 basis points each happening in 2016. This would put the Federal Funds Rate at between 0.75 percent and 1.00 percent by the end of the 2016. Fed presidents have said the Fed Funds rate would be near double that amount by the end of 2016. This means the market no longer takes the Fed's words as a certainty.
After 14 months of "imminent" Fed hikes that never materialized, investors have all but lost the little confidence they have left in the warnings of Fed officials and will lose what is left if no hike is made. This has become so exaggerated that any Fed official with access to a mic has strongly implied there will be a rate hike this month. A rate increase serves the interests and goals of several groups and therefore, a rate hike now may be unavoidable, despite data that begs further expansionary policies.
First of all, markets will have their faith in the Fed's words restored. "If we say, ‘we're going to raise rates, we're going to raise rates'," albeit a year later. The second group that wins is those that have been looking to further punish Russia for ignoring the threats of NATO and the United States. Russia annexed Crimea and those with the power to stand up to it gave it a slap on the wrist. A rate hike will further depress oil prices, further hurting Russia's ability to finance conquest.
Russia's recent escalation of its involvement in Syria and the broader Middle East is an affront to what has historically been an American sphere of influence. In the wake of the mass shooting in San Bernardino, California, U.S. President Obama addressed the country Sunday evening. In his speech he laid out his "strategy to destroy ISIL [DAESH]," as suspicions point to DAESH's rhetoric influencing the perpetrators. The third step of his strategy was to work "with Turkey to seal its border with Syria," and also work with "our allies but also countries like Russia." If you read between the lines, Obama means, Russia is not our ally, Turkey is, and we will pressure Russia while helping Turkey.
All these signals point to near certain action by the Fed next week, whether it will be in the form of a direct hike or expansion of the rate corridor is yet to be seen.
