What if Fed raises rate?

With only three FOMC meetings left over this for this year we should now be approaching crunch time. However, members have sounded more cautious of late, as uncertainties about the Chinese economy have come to the fore. The lack of a clear message has added to the confusion in markets. While it is a close call for 0.25% hike.

Raising rates at the next meeting, even as it is just 25 bps would signal a hawkish shift in the reaction function. The Fed would be conveying that despite the tightening in financial conditions and the decline in realized core inflation, it has now become reasonably confident that inflation will move back to its 2% objective over the medium term. This would imply that policy is being driven primarily by the unemployment rate, a notion the Fed has tried to dismiss in the past.

This suggests that the drag from the trade channel can persist through 2016 and that there is room for those growth forecasts to fall. Similarly, on the inflation front, YoY core PCE has drifted further away from the target, the USD has strengthened and energy prices have fallen since the June meeting.

The Fed's forecast in June for real GDP growth of 1.9% in 2015, rising to 2.55% in 2016 and YoY core PCE inflation to rise significantly to 1.75% by YE-16 from 1.35% at YE-15. With growth in the first half now looking better (at 2.15%), the Fed is likely to increase its 2015 forecast. However, at the same time, the tightening in financial conditions since the June meeting should weigh on 2016 forecasts.

We believe that financial conditions would tighten further in that scenario and it would be difficult to justify making policy less accommodative on the basis what the Fed has conveyed so far, even if marginally. We reckon the strengthening of the USD is likely to weigh on the Fed's forecasts the most. While the fall in energy prices may be expected to provide a boost, the sell-off in the equity markets should offset that. Vice Chair Fischer squabbled that a 10% appreciation would put forth a 0.3% drag in the first year but almost 0.5% in the second year.