Federal Reserve Board Chair Janet Yellen. (Photo: AP)

The Federal Open Market Committee is meeting Tuesday and Wednesday, when it will release a statement in the afternoon about whether it will raise the federal funds rate and its latest economic forecasts (also known as the “dot plots”).

“While the market has not priced in a 100% chance of a rate hike, it has come very close,” said Matthew Peterson, LPL Financial’s chief wealth strategist, in a commentary on Tuesday.

What might the Fed do?

“I do expect to see a rate hike tomorrow, not least because the markets expect it, but also because there seems to be a real shift in the Fed’s thinking, which has turned from worries about the risks of raising rates to worries about keeping them too low,” explained Brad McMillan, chief investment officer of Commonwealth Financial Network.

“Even the most dovish Fed members seem to have adjusted their positions recently,” McMillan said in a note shared with advisors and clients on Tuesday. “This says to me that the Fed is likely to keep raising rates. In fact, I would not be surprised to see language to this effect this week.”

As of Friday, June 9, the fed funds market was pricing in a 96% chance of a 0.25% rate hike this week. “Of the economists surveyed by Bloomberg, 73 out of 78 believe a rate hike is in store. This would bring the fed funds rate to a range between 1.00–1.25%,” Peterson explained.

Though the markets and the Fed are never “perfectly aligned” on the direction of interest rates, the LPL strategist says, they were “as close as they had been in a while prior to the March Fed meeting.”

Since March, market expectations have fallen considerably, Peterson points out. He says it will be “interesting” to see if the Fed moves to “lower its own expectations through the dot plots it releases” late Wednesday.

The last major disconnect between markets and the Fed, according to the LPL strategist, started in early 2016, right after the Fed’s first rate hike of the cycle in December 2015.

“At that time, the FOMC’s dot plots implied eight 0.25% rate hikes in 2016 and 2017, while the market expected just two 0.25% hikes. That large disconnect between the market and the Fed was one of the root causes of the imbalances that plagued global financial markets in late 2015 and the first few months of 2016. The divergence in recent months is not this severe, but is something worth watching moving forward,” Peterson said.

Fed Thinking

For McMillan, higher interest rates make sense for several reasons.

  1. With low rates, the Fed has limited room to cut them if the economy weakens again; raising rates in advance of the next recession makes sense.
  2. Financial conditions are fairly “easy” at present. The economy is doing better, and it could be harder for the Fed to hike in the future.
  3. Statistically speaking, the Fed’s goals have “largely been met;” rates should reflect that.

“All of this suggests to me that the Fed will indeed keep raising rates for the rest of the year,” the Commonwealth CIO explained.

“The real risk here is inflation, which is trending lower again. Unless inflation drops much more than it has, though, I think the arguments above still point to a need to raise rates,” he stated. “We will find out soon if the Fed agrees.”

— Check out Wall Street Signals Bond Yields to Stay Lower, Fed Hikes or Not on ThinkAdvisor.