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Words the markets want to hear

Traders work on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Traders work on the floor of the New York Stock Exchange.

Whether the Fed raises rates or not, markets may move more on its words than actions.

Traders have been betting against a central bank rate hike, so news of such an increase could get a negative response. But some say markets would be more relieved in the event of a rate rise if the Fed assures a slow path higher for rates, and it could do that in the interest rate forecasts of its members and again in its post-meeting news briefing. The markets will also seek a clear explanation of why the Fed did not hike, if it holds rates steady.

"It will be a case of watch what they say, not what they do," said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management.

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"To the extent of what they've been telling us so far is they're focused on the data," said Caron. "The data has been decent. The unemployment rate is low. Inflation is not where it needs to be but they've told us over and over, this is temporary." Caron said the question is whether the Fed will point to financial market conditions or not if it holds off raising rates, since the economy has met its targets and the Fed has said inflation would increase.

"Now what's the communication going to be? Is the Fed going to move when the Shanghai composite is stable? Is that the criteria for the Fed? If it's not on the U.S. economy what is it? That's where some of the credibility comes in, in terms of their communication. ... Is it the data or is it the international events," he said.

Caron said the futures market is pricing roughly 30 percent odds of a hike, but he sees a 50-50 chance. "If they go, I think it does not hurt their credibility because they've been telling us it's due to the economic data. It's better for their credibility to go in September. It is probably harder for their credibility if they decide to postpone it and go in December but they can justify it by saying they were really concerned about the markets and it didn't feel like it was the right time. So, I think the people will give them a pass."

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Even in the final hours ahead of Thursday's 2 p.m. ET Fed statement, Wall Street remains sharply divided over whether the central bank will raise the fed funds target rate for the first time in nine years or push it off to a later meeting.

"It's a big deal. It's the closest we've come to them actually doing something. It can happen," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi.

Some Fed watchers point to the fed funds futures and say the Fed will not move when markets are least expecting it. However, there is another camp that says the central bank will not get a better time if it waits, since the economy is mostly sending positive signals, and it will take the Fed a long time to return to neutral from the current near-zero rates.

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Stephen Stanley, chief economist at Amherst Pierpont, said the timing for the Fed to move is right. He said Fed officials should extend out their forecasts for interest rate rises if they don't hike. "But they have to try to offset that somehow. The truth is they probably wanted to go in September, but they may not because markets are volatile," Stanley said, adding the Fed would not use the markets as an excuse. "They can't do that or they hold themselves hostage to market volatility."

"I don't see what they buy themselves by waiting," he said. "If they're going to wait until financial markets calm down, that's an open-ended proposition. What if financial markets are more volatile in October than they are in September. I think they run a risk by not taking the opportunity to get going here," he said. If it does not hike, Stanley said the Fed would not say it didn't raise rates because of financial volatility, but it could say downside risks are greater because of weakness in the global economy.

Mark Luschini, chief investment strategist at Janney Montgomery, said the 2 percent rally in the S&P 500 on Tuesday and Wednesday was driven in part by traders betting the Fed would not raise rates as well as a rally in energy. He does not expect a rate hike, but says stocks would sell off if there was one. "I think it's unlikely but not implausible," he said. Luschini pointed to weaker CPI inflation data Wednesday as being among the reasons stock traders think the Fed could hold off.

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Rupkey said he expects a rate hike. "The only way they don't go is they'd have to increase the probability they are going at the next meeting," he said. Rupkey said the Fed will make clear it is closer to a rate hike.

"They can't say that they're going to wait for financial markets to settle down. They've already settled down," said Rupkey.

"They have to be reasonably confident. They could say the economy has made progress but they're waiting for a little bit more progress," he said.

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