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The most hotly anticipated U.S. interest rate decision in years comes down the pipe this week, and it promises to raise eyebrows, spark debate and send tremors through the markets, no matter what the U.S. Federal Reserve Board decides to do.
The U.S. central bank faces a difficult decision about whether to initiate so-called liftoff – to finally begin raising its key federal funds rate from the zero-to-0.25-per-cent basement it has occupied since the depths of the financial crisis. Fed watchers have had this Thursday's rate announcement circled on their calendars for months now, as improving economic indicators and comments from Fed officials suggested that liftoff was all but inevitable in the second half of the year.
But the summer's financial market upheavals, triggered by growing concerns around China's economic and financial health, threw a wrench into the conventional thinking. Rising downside global risks have given the Fed a new and, in some eyes, compelling reason to delay liftoff until the global outlook becomes more stable.
Now, the market is essentially divided on what the Fed will do on Thursday. Over the past week, the bond market has been pegging the odds of a September rate rise at about 40 to 45 per cent. A Wall Street Journal survey of economists found a similar split.
On the domestic economic front, the case for a rate increase has become pretty compelling. After a weather-related stumble in the first quarter of the year, the U.S. economy bounced back mightily to an estimated 3.7-per-cent annualized growth pace in the second quarter, and is expected to keep humming at something approaching 3 per cent in the second half of the year.
More importantly for the Fed, whose mandate includes maximizing employment, the sustained strong growth in the U.S. job market over the past two years has whittled the unemployment rate down to just 5.1 per cent. Many economists believe that this is approaching, or may have even fallen below, what is known as the "non-accelerating inflation rate of unemployment" (NAIRU) – the natural floor for unemployment, below which inflation is triggered by an overstretched labour market.
Typically, the approach of the NAIRU is a strong signal for the Fed to start raising interest rates – given that it not only fulfills its maximum-employment goal, but also raises an alarm for the second part of the Fed's dual mandate, to keep inflation stable. However, inflation itself hasn't been sending the same signal.
The U.S. consumer price index inflation rate was a puny 0.2 per cent year-over-year in July, a far cry from the Fed's objective of 2 per cent. But the Fed believes inflation has been muted by transitory factors, most notably the energy price slump and a surging U.S. dollar, which have obscured the underlying inflation pressures that have been building as the job market tightens. (Indeed, the U.S. measure of core inflation – which excludes the notoriously volatile food and energy components, and therefore removes oil's price plunge from the equation – is running at 1.8 per cent.)
One practical factor in favour of beginning to raise rates now is that this week's policy decision is one of four each year that also includes an update of the Fed's economic outlook and a press conference with chair Janet Yellen. Though it's far from written in stone, it's generally assumed the Fed prefers to time important changes in policy to coincide with its economic updates and press conference, to afford it a better opportunity to explain its rationale.
If the Fed were to take a pass on raising rates this week, it wouldn't have another full update-and-press-conference rate decision until mid-December – a long way off given the fast-improving U.S. economy, although it would still have the option of a rate increase at its less communication-intensive late-October policy meeting.
Regardless of what the Fed decides, though, its short and often cryptic statement accompanying the decision will be scoured by market participants for clues as to how fast the Fed intends to raise rates beyond September, as this will be a defining factor for global bond markets in the coming months. And Ms. Yellen, who has at times been prone to remarkably candid moments (at least for a central bank boss) in her press conferences, will get a thorough grilling from the media to shed light on the decision and the Fed's outlook. Expect financial markets to be hanging on every word.
Some pundits worry that the market has been putting too much focus on the timing of the Fed's liftoff, arguing that the September-or-no-September debate is far less important than the Fed's broader message surrounding its economic outlook and the likely pace of rate increase beyond liftoff, which up until now it has suggested will be slower than in past rate cycles.
"The difference to the economy of having the first rate move in September, October or December is negligible," said Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce. "If the Fed passes on a September hike, it will further tighten the language to reinforce expectations that a move is still highly likely this year. If it raises rates, it might add a line saying that it will be 'patient' in terms of subsequent moves, virtually ruling out an October move in the process. For anyone other than money market traders, these are not radically different outcomes."