All signs point to Fed rate hike next week

 As the Federal Reserve’s Federal Open Market Committee (FOMC) prepares to meet next week for the final time this year, financial markets widely expect the Committee to raise its policy interest rate by a quarter of a percentage point, which would mark the first such move this year and only the second since the Great Recession ended in 2009. 

Fed Chair Janet Yellen and the Committee have argued for a patient approach to monetary policy, and the Fed has certainly followed that strategy this year.  The Committee came into the year projecting four quarter-point rate increases in 2016, but made it through the first 11 months of the year without moving at all.  So, why is the Fed likely to hike next week?

The main rationale for a rate raise is that the economy has made solid progress in 2016.  While it remains anemic by historical standards, economic growth has been strong enough that the labor market continues to tighten.

 Job growth has averaged about 180,000 per month, somewhere close to twice the pace needed to keep up with underlying population growth.  As a result, the unemployment rate has fallen below the level that Fed officials have signaled is consistent with “full employment,” one of their two Congressionally-mandated goals for the real economy.

Full employment does not mean that every able-bodied adult has a job. Rather, it is the level of unemployment that over time is consistent with a labor market balanced between supply and demand, i.e., one that would lead to steady wage and price inflation.

The Fed’s other mandate is to maintain stable prices, which the FOMC has chosen to define as a 2 percent inflation target.  Entering 2016, inflation was clearly underperforming the Fed’s target, as headline inflation was running at less than 1 percent due to plunging energy costs.

So-called “core” inflation, which strips out the volatile food and energy components, was below 1.5 percent by the Fed’s preferred gauge.  However, as oil prices have rebounded, headline inflation has accelerated. 

The latest year-over-year inflation reading (for October) came in at 1.4 percent and a further pickup is likely over the next few months as energy prices continue to rise on a seasonally adjusted basis.  Similarly, “core” inflation has risen to 1.75 percent and may inch up further in the coming months.

In sum, while inflation is still running a little short of the Fed’s 2 percent target, it is making up ground pretty fast and a path to 2 percent over the next three-to-six months is easy to see.

The FOMC projected at the end of 2015 that it would hike rates multiple times in 2016, but events intervened to dissuade them.  The year began with very disruptive market movements in January and February, as a swoon in equity prices driven by fears of global economic weakness pushed off any thoughts of a rate increase. 

Once financial conditions normalized in the spring, Fed officials seemed to be preparing the way for a June move, but a weak May employment report spooked them, and the market gyrations and fears of economic disruption that followed the Brexit vote in late June stayed the Fed’s hand into the fall.

Finally, as the year winds down, all of those external headwinds that kept the Fed on hold have dissipated, and officials have once again paved the way for a rate increase at the December FOMC meeting. 

Some observers had felt that the election could provide a shock that would once again sideline the Fed, but the post-election reaction in financial markets has actually reinforced the need for the Fed to move, as equity and bond prices reflect expectations of stronger growth and possibly higher inflation in light of the proposals of the incoming administration.

Assuming that the Fed does indeed raise rates next week, the question turns to whether 2017 will be a third consecutive year in which the central bank moves only once, or will the pace of policy normalization pick up.  In my view, the economic situation will dictate a quicker pace of rate hikes in 2017. 

Labor markets have been steadily absorbing the slack that developed during the steep downturn of 2008-2009, and we currently have a tight labor situation, as reports of firms who are unable to find qualified candidates to fill openings have multiplied. 

Wage gains have begun to accelerate and are likely to continue to do so, putting additional upward pressure on prices.  While consumer price inflation remains below the Fed’s 2 percent target at the moment, I expect it to move past it in 2017. 

While inflation above 2 percent would be far from a disaster for Fed officials, the trouble is that monetary policy will still be providing considerable stimulus at a time when the economy is beginning to overheat. 

The Fed does not like to make abrupt changes to its policy rates, for fear of disrupting the economy, so officials will likely need to hike rates between two and four times next year to bring policy closer to a setting that is consistent with an economy operating at full employment already. 

Waiting too long risks allowing the economy to overheat, which in the past has generated inflation and forced the Fed to make the sort of rapid rate increases that have often lead to recessions. 

Stephen Stanley is the chief economist at Amherst Pierpont Securities.

The views expressed by contributors are their own and not the views of The Hill.