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Why Janet Yellen Could Blindside Markets

April 26, 2016, 6:21 PM UTC
Yellen Testifies At Joint Economic Committee Hearing On Economic Outlook
WASHINGTON, DC - DECEMBER 03: Federal Reserve Chairman Janet Yellen testifies before a Joint Economic Committee hearing on Capitol Hill, December 3, 2015 in Washington, DC. The committee is hearing testimony from the Chairman on the United States economic outlook. (Photo by Mark Wilson/Getty Images)
Mark Wilson—Getty Images

Janet Yellen and the Federal Open Market Committee convene their third meeting of 2016, and Wall Street is expecting a real snoozer.

While Fed minutes show that at least some members of the committee think the central bank should restart the process of moving interest rates higher, futures markets say there’s zero chance that Yellen and company will raise interest rates this week. This appears to be a pretty sound bet. Fed minutes clearly show that the majority of committee members aren’t ready to raise rates during a week during which the preliminary data indicate we will get yet another disappointing GDP report come Thursday.

But as we look ahead into the future, the market’s confidence that the Fed won’t raise rates further looks more dubious. According to Bloomberg data, the markets are giving just a 18.8% chance that the Fed will hike twice in 2016, whereas every FOMC member save for one thinks that there will be two or more hikes this year, according to the projection materials released following the last meeting in March.

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In other words, something’s gotta give. But it’s not like we can blame markets for not having the utmost faith in Federal Reserve projections. The central bank has consistently overestimated the pace of economic growth since the end of the financial crisis, and therefore underestimated the amount of monetary stimulus it would need to provide the economy. And so it appears that traders are taking the Fed’s faith that economic conditions will improve enough over the next eight months to warrant two rate increases with a grain of salt.

But this divergence between where the Fed sees the economy going and what traders predict will happen could very well be cause for increased volatility in financial markets in 2016. The Fed is counting on the idea that economic turmoil abroad will settle down, and falling unemployment will soon cause a rise in inflation that will necessitate higher rates. The market’s view is that the economic malaise has characterized the current expansion will be sustained by rising income inequality and technological developments that lessen the need for companies to hire large numbers of workers. Combine that with continued economic weakness in the global economic that puts a premium on safe assets like U.S. government debt, and it’s unlikely that the Fed will be able to push rates higher in the near future.

Both of these theories are plausible and can be backed up with data. But the longer central banks and the market disagree with each other, the better the chances that the Fed deals a big surprise to investors.