Investors will be paying close attention this week to the Federal Reserve’s two day March policy meeting that wraps up on Wednesday and is expected to provide more clarity about how soon the U.S. central bank plans to raise interest rates.
Policymakers in the Federal Reserve have been scrutinizing recent economic data for signs about the resiliency of the U.S. economy that is influenced by interest rate policy decisions.
Raising interest rates will cause ripple effects across the entire economy as it impacts how much borrowers are left paying for credit purchases in areas such as construction, business investment, and home loan interest rates.
When the Federal Reserve keeps interest rates historically low with the federal funds rate, as it has been doing since December 2008 during the depths of the recession, borrowing money becomes cheap which entices people to borrow money and stimulates the overall economy.
Conversely, when interest rates are low, savers earn little interest keeping money parked in the bank.
Deciding the correct time to lift interest rates is never an easy task for a central bank, especially when central bank policymakers hold diverging views about economic principals that govern and shape policy decisions.
The two major drivers of Fed policy concerning interest rate hikes are job growth and inflation.
Typically, when job growth expands and inflation rises at a healthy pace towards economic targets, the Federal Reserve has a “green light” to begin raising interest rates.
Currently, the trend of job growth in the U.S. has been largely positive and robust with monthly job growth averaging well over 200,000.
Fed Chair Janet Yellen said before the Senate Banking Committee last month that “considerable progress” has been achieved with job growth.
She cited the 5.7 percent level for January along with the 280,000 job gains created per month during the second half of 2014.
But Yellen also pointed to signs of weakness with U.S. wage growth and the labor force participation rate.
On the other spectrum, inflation keeps declining, showing that the U.S. economy is not quite running at full pace.
Falling energy prices and weaker global growth are partly to blame, adding to deflationary pressures.
The Federal Reserve has a 2 percent inflation target and prefers looking at inflation data through the prism of core PCE (minus food and energy) over core CPI because it is less volatile.
Recent core PCE (Personal Consumption Expenditures) inflation data has been dropping over the past 9 months, leading to more uncertainty about whether the economy is truly ready to absorb an interest rate hike.
In January 2015 core PCE was 1.31 percent compared to 1.34 percent in December, 1.41 percent in November, and 1.48 percent in October.
By contrast in March 2012 PCE was 2.04 percent. The next PCE inflation reading for February will come on March 30th.
Fed Chair Yellen explained that more inflation and labor data are needed before an interest rate hike can be reached by Fed policymakers.
Most economists and investors are watching to discover if the Federal Reserve removes the word “patient” from their released statement about when the central bank will hike rates. Removing the “patient” word is generally viewed as an indicator that the Fed plans to hike rates fairly soon in June versus September or in 2016.
Meanwhile, first quarter 2015 U.S. GDP forecasts are being lowered due to colder than normal weather across much of the country, similar to what was experienced last year.
Another economic headwind that Fed policymakers will likely pay attention to during the next Fed policy meeting this week is the rise in the U.S. dollar which makes American goods more expensive on the international market and recently hit a 12 year high versus the euro shortly after the European Central Bank (ECB) decided to engage in monetary stimulus by keeping interest rates near zero and engaging in a €1.1 trillion euros quantitative easing (QE) program that amounts to buying €60 billion of public and private bonds each month.
Monetary easing by the Bank of Japan has also helped to raise the U.S. dollar over 20 percent higher since mid 2014.
The Bank of Japan will make a policy decision on Tuesday, one day before the U.S. Federal Reserve reaches a decision. The Bank of Japan is expected to maintain their current pace of monetary easing through asset purchases.