The Federal Reserve at long last appears ready to raise interest rates and commence the normalization of U.S. monetary policy at the upcoming December 15-16 FOMC meeting.
The much stronger than expected October employment report and services purchasing manager index report have given the data-dependent Fed a green light to increase the overnight Fed fund interest rate for the first time in nearly a decade.
Core consumer price inflation of 1.9% at the end of September also appears to be increasing confidence within the Fed that core inflation will eventually return to and stabilize near the stated 2.0% objective.
If the FOMC is indeed within weeks of hiking interest rates and the commencement of the first tightening cycle seen in a decade, the question immediately arises, how quickly and how far will the Fed further tighten monetary policy in 2016? S&P Capital IQ Global Markets Intelligence (GMI) believes that the Fed will prefer to adjust policy very slowly at an extremely measured pace in the year ahead.
Careful consideration must be given to what effects the first tightening seen in 10 years will have on the term structure of market-controlled interest rates, and then U.S. economic activity.
Back in the spring of 2013 when the Fed foreshadowed the end of QE3 and triggered what is commonly referred to as the “taper-tantrum,” the 10-year Treasury note yield quickly increased from 1.66% at the beginning of May to over 3.0% at year-end 2013.
The taper tantrum also drove 30-year mortgage interest rates significantly higher, sending such a chill through the housing market, that it took up to two years for the housing market to recover from the aftershocks of the tantrum and rising bond yields. Mortgage applications to purchase homes for instance has yet to recover to pre-tantrum levels on a sustained basis (see chart).
GMI Research believes that the Fed, at minimum, needs to hike rates by 75 bps relative to current core personal consumption expenditure deflator inflation of 1.3% as of September 2015. As long as there's a wide gulf between the performances of the largely U.S. service sector-oriented economy and that of the manufacturing-related portion of the economy, and the U.S. continues to display much healthier growth than the rest of the world, the Fed will prefer to be nearly as cautious about snugging monetary policy in 2016 as they have proven to be while building a consensus on the appropriate timing for the lift-off of policy normalization since the start of 2015.