A key week in Forex | the size of a US Fed interest rate rise

Today sees the start of what could be a significant week in Foreign Exchange and other tradable markets. On Thursday, the US Federal Reserve will release its monetary policy statement and interest rate decision after its two-day meeting. Although the bond market has priced in only a 33% chance of a start to an interest rate rising cycle at this meeting, there are a number of reasons why there might be a surprise in store.

If it is to happen, it will be the first rise since 2006, which is ten years ago. When rates next moved it was for the Fed to embark on an easing cycle that resulted in a drop in the funds rate from 5.25% all the way down to the current 0.25%. This rate has lasted since 2008 up to the present.

In attempting to anticipate the outcome of the upcoming meeting, commentators have been considering four main factors: the volatility of equities, vulnerable emerging market economies, inflation and jobs. Of course there are others, such as GDP, but the four mentioned above are most in the spotlight. Two main reasons why there may be a surprise have to do with equity price volatility and emerging market (EM) perceived vulnerability. Some commentators believe that the Fed will hold off on rates until stocks show signs of stabilizing, and/or because of worries about how EMs, especially China, will impact the global economy. But members of the FOMC (Federal Open Markets Committee) are on record as saying that they do not see the stock markets as a part of the “real economy”, and Janet Yellen herself has made it known that the overriding concern of the committee in these matters is the domestic situation in the US, not what happens in or to emerging markets. And at home the focus is on inflation and jobs.

The unemployment rate in the US is now running at 5.1%, which many regard as full employment. Participation rates and wages are also increasing.

That leaves inflation. There is a welter of inflation reports due this week. Later today we will hear about consumer prices in Finland, producer and import prices in Switzerland, and the Consumer Price Index from Italy. Tomorrow (Tues) come consumer prices from France and both consumer and producer prices from the UK. Then, from the US itself, the Consumer Price Index is on Wednesday, the first day of the two day FOMC meeting.

Tomorrow (Tues) also sees retail sales stats from the US.

As inflation and retail sales are official government figures, no doubt the committee will have advance notice of these particular numbers.

How much to raise rates by

Whatever about the timing, there is no doubt that the next move on interest rates in the US will be to the upside. Normally rises are either 0.25 percentage points, or 0.5 percentage points (otherwise known as 25 and 50 basis points).

At a recent very enjoyable dinner with three MBA colleagues, all of whom are engineers, this matter got an airing. Topics were robustly discussed. When a possible Fed rate rise came up there was tentative agreement to the proposition that the above mentioned figures are just that, numbers (and these guys understand numbers). There is no law that says the Fed cannot, on Thursday, raise rates by as little as 10 or 12.5 basis points.

The argument for such as small rise is as follows: there is still a fear on the part of at least some members of the Fed that putting up rates now might be premature. However, when it does come, any rise will be traumatic for the markets, purely because it has been so long since one took place. How better to signal that the era of almost zero rates is over than to do so with a rise that is so small that it will have nothing more than a psychological effect on the economy and the markets? Might it not be better to get that out of the way before real rate rises are put into effect?

It made sense to me.