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How Likely is a Fed Rate Hike Before the End of the Year?

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Extraordinary circumstances require extraordinary measures, so the usual projections for what the Fed will do might not hold up.

The post-covid situation isn’t like other post-recession scenarios. Therefore, many models that analysts use to project where currencies and markets could be going might be in for a shock later this year by the Fed.

On Wednesday, the markets priced in the increased possibility of a taper, according to the minutes of the last FOMC meeting. This fits in the usual model that we’d expect from the Fed; gently breaking the news about a potential change in policy ahead of time so the market begins to adjust.

But things just aren’t normal

The Fed’s optimism might seem misplaced in light of the latest NFP. But, that was only one month of data, and by no means confirms a trend.

Just yesterday we saw a pandemic low of people seeking unemployment benefits. May NFP figures might just be a bump in the road to recovery, not the sign of a new trend.

The current consensus is that the Jackson Hole Symposium is the moment for the Fed to finally start winding down asset purchases. This follows the usual logic that the Fed will start to taper first, then look to potentially raise rates, maybe a year later.

There isn’t a good track record

Chairman Powell is in a particularly complicated situation.

When he took over from Yellen, who oversaw the first rate hike in half a decade, the Fed went on a rate hike spree in the lead-up to the covid pandemic. Many at the time said it was ill-advised. They claimed that the Fed had previously pushed the markets with poorly timed rate hikes.

There is a standard impression that when the Fed starts raising rates, it will keep doing so until forced to cut by the next recession. That provides extra nervousness for stock market participants because the lower liquidity puts a damper on index growth.

The Fed’s reputation for tightening is compounded by Powell’s reputation for tightening. So, any potential hint at a rate hike from Powell might seriously spook the markets, as they will likely see it as the start of a steep rise in rates.

The potential for extraordinary policy

That scenario isn’t certain, however.

The Fed additionally has to deal with the problem of massive amounts of cash sloshing around the economy from an unprecedented level of Federal spending. In order to keep rates from rising on public debt, the Fed has been buying extraordinary levels of Treasuries.

A taper in the middle of the government issuing more debt to pay for the stimulus activities might significantly distort the bond market.

Combining the Federal government’s funding needs with the potential for inflation might revere the usual process of tightening. The Fed might find it more convenient to keep buying Treasuries, but at the same time try to control liquidity with higher rates.

That is, supposing their outlook that inflation will moderate by the end of the year doesn’t work out. If inflation continues its current trajectory, then the Fed might have to look at alternate measures.

However, last month’s inflation numbers might also be a fluke. Whatever happens, the next FOMC meeting is going to be really interesting.

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