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Fed preps for rate hike, but markets will want more


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Fed preps for rate hike, but markets will want more

Top Federal Reserve officials will meet this week amid widespread expectations in financial markets that they plan to lift the U.S. central bank's key interest rate for the first time this year.

Voting to do so would mark the latest key step in Federal Reserve Chair Janet Yellen and other policymakers' ambitions to normalize rates from the near-zero levels where they sat for more than a half-decade after the financial crisis.

The Federal Open Market Committee begins its final policy meeting of 2016 on Dec. 13, and policymakers may be in the best position they have been in all year to continue a normalization process that has been repeatedly delayed throughout the year by global growth worries, data surprises and political uncertainty. Headline unemployment has continued to hover around 5% despite some surprises, and inflation has rebounded to levels much closer to the Fed's 2% long-term target.

Perhaps most importantly, they have convinced markets that have alternately been jittery about economic developments or outright skeptical that Fed policymakers were committed to lifting rates. "They have a grand opportunity" to move rates up, said Steve Feiss, an interest rate strategist with Government Perspectives.

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Committee members described their deliberations on a rate hike as a "close call" during their September meeting, and minutes of their November meeting revealed that they agreed a rate hike would be warranted "relatively soon." They have pointed to the continued strength of unemployment number and it seems a majority of policymakers believe labor markets are at or near full employment, which is historically an indicator that it is time for the interest rate cycle to reverse.

"The key for them is that they've managed to get markets accustomed to the idea of an interest rate hike without an appreciable tightening of financial conditions. It's been very widely assimilated, and it's accepted that they're going to hike," Aaron Kohli, a fixed-income strategist with BMO Capital Markets said in an interview.

The message from policymakers has clearly been received by investors: The CME Group's Fed Fund futures showed Dec. 9 that markets are projecting a 97.2% chance that policymakers will lift the target range for the federal funds rate at this week's meeting.

The price of the success of the Fed's communications strategy, however, is that investors are already beginning to look beyond the expected rate hike announcement and speculating on how the impending presidency of Donald Trump will affect the Fed's outlook for next year. Fed officials have been mostly noncommittal on that subject, but they may be keen to give markets some guidance on how Trump's administration and Republican control of government might change their policy stance.

"I think that means the key for them over the next few days is how they prep the market for what their thinking about next year will be, what they foresee happening next year," Kohli said, though he acknowledged that given Trump's campaign attacks on the bank that "it's possible they don't really have the details either."

Some investors are already betting that a "reflation" environment will finally drive inflation above the Fed's targets. Inflation has been edging closer to the Fed's long term target in recent months, and major fiscal stimulus from the Trump administration, combined with the bank's accommodative monetary stance, could push GDP growth into a higher gear. "The market is pricing in — whether it's equities, real yields, inflation expectations — that everything is green-lit and ready to go," Feiss said.

Kohli agreed, saying that Fed officials are likely aware of this sentiment and will want to make sure they offer some hints about their options if the economic situation suddenly shifts. Investors, he argued, are not only expecting to come away from the meeting with higher interest rates but also insights into how the Fed is viewing "the risks and what they think a plausible path would be if GDP does rise next year."