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11 24 2015 | by Victor Xing | Central Banks

Should the Fed raise interest rates in December?

Reasons for the Federal Reserve to raise interest rates in December

FED officials have made a conscious effort to not surprise the market following averse reactions such as the 2013 Taper Tantrum.  Some argue that policymakers would only proceed with major policy changes (such as raise interest rates) when they are more than 50% priced-in, and recent FED communications did just that – setting investor expectations of a December “liftoff.”

Below is a time-series of market-implied probability of December “liftoff.”  The more dovish than expected September FOMC successfully “reset” investor expectations following China growth concerns and another bout of energy weakness.  Nevertheless, hawkish communications at the October FOMC and subsequent policy speeches again raised “liftoff” expectations.

Expectations are set that the FOMC will raise interest rates at the December meeting
Source: Bloomberg data on Jan 2016 Fed Funds futures, New York Fed data on effective funds rate.  Calculation methodology: (futures-implied funds rate – effective funds rate at zero lower bound) / expected rate following rate hike

Financial markets would react with shock if the FED goes against the “December consensus” without notable changes in economic conditions, downside surprises may include a significantly weaker-than-expected Dec 4th employment report, oil dropping into the low 30s range, another round of below-consensus China data (major data release on Nov 30th).

In terms of data, I would like to highlight the steady rise in core inflation (ex-food energy), and how energy weakness is weighing on headline inflation.  Inflation had been the FED’s main concern, and if the FED is willing to look past energy price decline as “transient,” and assuming oil prices stay in the current range and China growth doesn’t deteriorate, FED policymakers will ease their concerns on inflation at the December meeting, paving the way for rate hike.

Decision on whether to raise interest rates will hinge on inflation

In terms of the labor market, U-6 and U-3 are both crossing into “pre-recession” levels, and involuntary part-time workers have declined further.

Labor market conditions support raise interest rates in December

Please also refer to:
October Payrolls (Nov 6th) and Federal Reserve policy implications
October Consumer Price Index and Federal Reserve Policy Implications
October FOMC Minutes – dovish rate path deliberations amid expectedly hawkish liftoff language

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