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luc vallée

Luc Vallée is chief strategist at Laurentian Bank Securities.

Here we are again, days from yet another Federal Reserve meeting to decide whether to increase U.S. interest rates for the first time in more than nine years.

This time should be the one, though. As former Fed vice-chair Alan Blinder wrote recently, "Only the stubborn remain unconvinced" that liftoff will happen next Wednesday. And I concur. Barring a disaster, Fed chair Janet Yellen would lose too much credibility if she did not deliver the long-awaited hike.

But, as some Fed officials have warned, too much attention is being paid to the timing of the first move rather than the path of subsequent rate increases. Credibility aside, there are excellent reasons for the Fed to finally want to move away from its zero-interest-rate policy (ZIRP), which was adopted after the financial crisis. And let's face it, a mere 25-basis-point increase will not be the end of the world, but rather just the beginning of the monetary-policy normalization process.

Moreover, the neutral interest rate (the short-term policy rate consistent with stable inflation at full employment in the long run) might be lower today than it has been in the past. But, according to the Fed's own research, the neutral rate is still likely to be around 3.75 per cent, a long way from where the Federal funds rate stands today.

Assuming that next week's rate hike is a forgone conclusion, investors should turn their attention toward what the Fed is likely to tell us about its intentions for 2016 and beyond. Since September, 2014, it has been saying that over a 15-month horizon, the funds rate should increase by about 1.25 per cent, or 125 basis points. But the Fed has not moved since; all it has done is to roll forward these future rate increases. For instance, in September, 2014, the median of the "dots" (the policy rate forecasts of each member of the Federal Open Market Committee) called for the rate to reach 1.37 per cent – or for five rate hikes – by December, 2015. Yet, in September, 2015, one year later, the median "dot" was still pointing to the same rate of 1.37 per cent but, this time, to be delivered by December, 2016.

This 15-month forward rate forecast by the Fed is thus now much less credible. And the bond market has, unsurprisingly, adjusted its expectations to take into account the Fed's failure to deliver on its own guidance. Bonds are now pricing increases of between 50 to 75 basis points (i.e., two or three hikes) for the whole of 2016. This is a significant divergence from the Fed's view, which still officially anticipates that it will move by 25 basis points every two FOMC meetings (there are eight a year), while the market roughly thinks the Fed will hike similarly every four meetings.

And over a longer horizon, the expectations of future rate increases have also diminished. In September, 2014, the market may have been inclined to believe that the policy rate would move to 4 per cent after a few years, but investors on the bond market now implicitly forecast that the rate increases by the Fed beyond 2016 will be spread over a much longer period and end at a much lower rate than what the current "dots" suggest. The U.S. 10-year bond yield is 2.20 per cent and the 30-year rate (a good proxy for what the market thinks the upper limit of the neutral rate should be) stands at 2.95 per cent.

I believe that at its next meeting, the Fed will adjust to this new reality and communicate its thinking to the market in order to provide a more favourable environment to foster economic growth. This communication will be crucial, because many financial market participants still fear that once the Fed starts raising rates, there are considerable risks that it may tighten too soon and faster than warranted. One way to assuage this fear would be for the Fed to credibly signal that it recognizes the current economic recovery, domestic and global, stands on weak foundations and excessive leverage, and could relapse if pushed too hard.

Yet the United States is almost at full employment, and although inflation is below the Fed's target of 2 per cent, there are reasons to believe this weak price environment is temporary, as energy and non-energy commodity prices are currently at cyclical lows. The timing and the rationale to raise rates are thus appropriate, especially given that monetary policy works with a lag.

What is the problem, then? One problem is that the recovery is much less firm in the rest of the world than it is in the United States, and as the Fed starts raising rates, global liquidity will begin shrinking, putting even more downward pressure on consumption and investment.

Preventively, other central banks – most notably the European Central Bank and the Bank of Japan – have launched massive asset-purchasing programs to compensate for the anticipated reduced global liquidity the Fed's restrictive monetary policy will have once it starts raising rates. As a result of these pre-emptive expansionary policies outside the United States, the U.S. dollar appreciated significantly against the euro and the yen in the past year, although the Fed has yet to tighten. This would have been all very good had those depreciating currencies led to more growth in Europe and Japan in 2015. But, as in Canada, the positive effects of these engineered currency depreciations remain works in progress. In other words, despite all the stimulus recently provided by non-U.S. central banks, global growth is still tepid, an embarrassing outcome for policy-makers.

Conversely, the U.S. dollar's appreciation has considerably slowed U.S. exports and growth in 2015. Fed vice-chair Stan Fischer, relying on a model developed at the Fed, acknowledged in a speech last month the negative impact an appreciating dollar has on U.S. growth. This may go a long way toward explaining why the U.S. economy's performance was below most economists' expectations this year. Ms. Yellen also explicitly recognized the phenomenon in a more recent speech, when she said the appreciating dollar probably cut U.S. growth by 0.5 per cent in 2015.

But, more important, Mr. Fischer argued the negative effects of the 2015 appreciation of the dollar are likely to unfold over time, and consequently could affect U.S. growth next year and beyond: "Recalling that the dollar's actual appreciation has been about 15 per cent, … the cumulative reduction in U.S. aggregate demand from the dollar appreciation is likely to total 2.5 per cent of GDP after three years."

From there, it is easy to conclude that the last thing we need today is a further appreciation of the U.S. dollar. U.S. growth in 2016 will be affected negatively by the dollar's appreciation over the past 12 months, but growth could be even lower if it appreciates yet again next year. Furthermore, growth could deteriorate even further, and for several years, if the dollar were to pursue its ascension toward new highs.

Given that the American economy is one of the few engines – if not the only engine – for the global economy these days, slowing U.S. growth surely does not sound like a winning strategy for promoting world growth. It also does not look like a wise path if one wants to avoid a disorderly devaluation of the Chinese yuan in the near future, as the likelihood of such an event is more likely as the dollar strengthens and U.S. growth falters.

Reading between the lines in both Mr. Fischer's and Ms. Yellen's most recent speeches, as well as in European Central Bank president Mario Draghi's underwhelming policy response to Europe's woes last week, we can gather that central banks are most likely co-ordinating their efforts to stabilize the U.S. dollar. Implicitly, they are also contributing to stabilizing the yuan.

Where does that leave us next week after a Fed rate hike? In my opinion, the real news on Wednesday is not that the Fed is putting an end to seven years of ZIRP, but that it is reducing the speed at which it intends to raise rates going forward, tacitly aiming to stabilize the dollar.

The Fed is likely to do this by lowering the "dots" from four more increases in 2016 to just two. It may also further lower the long-run neutral rate to 3.0 per cent or less. In doing so, the Fed would credibly acknowledge that it underestimated global headwinds and the negative effects of the rising dollar on both U.S. and global growth. It would also signal that it intends to take the time needed to raise rates to the neutral rate while remaining data-dependent. This would also go a long way in calming nervous market participants and reducing uncertainty. This may even help to create a more favourable economic environment for business investment and job creation.

However, such a statement would likely complicate the Fed's conduct. Its dual mandate today calls for stabilizing inflation and maximizing employment. It might never admit to it, but going forward, the Fed may have to actively try stabilizing the dollar.

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