Will the Federal Reserve at the FOMC meeting next week increase the repo rate?

Virtually everybody agrees that the Federal Reserve (Fed) needs to raise the repo rate. The question is will the Fed raise the rate next week or will it defer the decision to October/December or perhaps even early next year?

The argument for and against have been put forward recently in the Financial Times by two reputed economists.  Readers of my blog would best be served by reading it.

My view is that at this juncture it is perhaps better for the Fed to hold off raising rates till December.

There is the recent argument that the Fed has created uncertainty in the minds of market participants: they were   expecting a rise, and now – given fear of a potential China shock and contagion – they are not sure whether the rise will materialise. The argument goes on to add that there will always be some unknowns for the Fed., so it is best to act now rather than wait.

While there is some truth to this argument, the fact is that the Fed has eased uncertainty for over a year: it announced that the next move in interest rates is going to be up about a year ago, and this gave participants time to take action – the massive and arguably unprecedented outflow of capital from emerging markets over the last year was partly a result of this guidance by the Fed. , and this has eased the transition process of the reverse flow of capital to emerging markets.

It is unlikely that, on its own, a Fed. decision to raise the repo rate next week will create a major furore in the financial markets. But if this is coupled with a China shock and contagion, then the result could very well be different. Recent turmoil in the financial markets is a warning sign.

Second, there is really no pressing imperative for the Fed to raise the repo rate: inflation in the US is very benign, and there is yet no clear sign that it is likely to surge ahead, and the world has witnessed a deflationary commodity shock, which by most accounts has not run its full course.

In fact we could be facing a ‘new normal’ in the US: a period of steady growth in the region of 2 -2.5% with inflation below the Fed’s target of a healthy level of inflation of 2%.

Yet, there is, I believe, a sound reason for the Fed to raise rates – the Fed needs to normalise interest rates. With inflation in the region of 1.5%, under normal circumstances, the Fed’s target for the repo rate would be 3 -3.5%, against a background of an economy growing at 2-2.5% with unemployment at low levels. Savers getting a cipher on their bank saving is creating distortions in the economy.  And it is just not fair.

If in October/December, purely on domestic grounds, the Fed gets clear signs that it is imperative to raise the repo rate and we have no China shock (even a hard landing is fine), then it should do so.