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Fed-in-a-box: Will there ever be a good time?

Reduced expectations for economic growth, corporate earnings and stock market gains hardly seem the ideal climate for raising interest rates, but such is the box in which the Federal Reserve finds itself.

Each concern was highlighted Tuesday in a Goldman Sachs analysis that gained significant Wall Street attention. The bank's strategy team cut its full-year S&P 500 earnings estimate by 4 percent to $109, its gross domestic product projection for 2016 by 14 percent to 2.4 percent and further knocked down its year-end target for the stock market index, from 2,100 to 2,000. If that wasn't enough, Goldman also cut its global growth expectations for next year, from 4.3 percent to 3.7 percent.

"Flat is the new up," Chief U.S. Equity Strategist David Kostin and his team proclaimed as the new motto for investors in 2016.

Don't expect those words to show up in any presidential campaign slogans.

The downbeat outlook comes as the market waits on tenterhooks for the Fed to make a move on interest rates. Expectations, including from Goldman, are that the U.S. central bank still will hike this year, probably at December's Federal Open Market Committee meeting.

But faced with a bogged-down economy and the prospect of a government shutdown either in October or December, the Fed will find itself hiking into a less-than-ideal environment.

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"They sort of made their bed, didn't they?" said Jim Paulsen, chief investment strategist at Wells Capital Management.

Janet Yellen
Mary Schwalm | Reuters
Janet Yellen

Indeed, the Fed has been stuck at zero since late 2008 and could have used any number of opportunities along the way to raise rates but has chosen to stay ultraeasy, each time finding a new rationale for not moving.

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Like many other market participants, Paulsen said Friday's nonfarm payrolls report could mark the final point after which the Fed will have no choice but to raise. Economists expect the data to show creation of 206,000 new jobs and an unemployment rate holding steady at 5.1 percent, according to FactSet.

More importantly, Wall Street will be watching for signs of wage growth. The projection is for a climb of just 0.2 percent, pretty much in line with the slow pace over the past seven years, but a sudden jolt, signaling an inflation surge, could cause big problems for the Fed.

"The real bad scenario would be that you just get some shockingly outsized wage (gain). Then there would be absolutely nothing they could do but raise rates, and they'd have to raise in a panic," Paulsen said. "At that point, that would be really bad. I don't think that's the most likely outcome, but it wouldn't be shocking."

How the market would take a move is difficult to gauge, but it's worth remembering that Goldman's reduction in its S&P 500 price target and its belief in a rate increase still factors in a market gain of about 6 percent through the rest of the year.

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That view looks even more optimistic considering that S&P 500 earnings are expected to have declined 4 percent in the third quarter and to register as barely flat in the fourth quarter.

Market confidence in central bank policy, then, will be critical. Stocks are currently in correction territory, with each of the major averages down around 12 percent from their 52-week highs.

"We believe the Fed as well as the rest of the world's central banks are losing their grip on market prices and that markets are likely to remain volatile while they adjust for either the (slow) removal of crisis-era policies or the waning effectiveness of them," Tony Crescenzi, market strategist at bond giant Pimco, said in an analysis. "As central banks lose their grip, market prices will be on the move."

Judging by futures activity, traders believe a recent round of hawkish talk from top Fed officials is mostly bluster. Traders assign just an 11 percent chance of an October hike, a 39 percent chance in December and a 48 percent probability all the way out into January.

In fact, some in the market believe in a scenario expressed from a couple of members at the last FOMC meeting who said negative rates are a possibility ahead.

"Considering the Fed's starting point, 2016 could be the year when we see negative fed funds as a way of getting money velocity moving up rather than down," Bob Janjuah, an often-bearish fixed income strategist at Nomura, said in a note to clients. "Such a move may work, in that risk assets could react very positively for a period of time, but in the longer run any such moves would only serve to highlight the extraordinary ongoing failure by global central banks to manage economies (both into and) since the 2008-09 crash."

To be sure, there are those on Wall Street who believe the Fed actually has waited too long to raise rates and needs to get moving.

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Citigroup economist Peter D'Antonio said the FOMC may have been too swayed by an August jobs report—just 173,000 new jobs—that is notoriously volatile and likely will get revised higher.

"We continue to believe that the Fed has enough evidence of labor market improvement and can make a case for inflation reverting to the 2 percent target in the medium term," D'Antonio said in a note. "So the timing of the first rate hike will depend on how quickly the uncertainty and implied drag from international and financial risks (including potential fiscal developments in December) play out and how much weight the Fed gives to these respective influences."

Paulsen, too, believes the Fed, despite the obstacles ahead, is better off making its move sooner rather than later.

"This market is finding a new level that's more like 15 or 16 times (earnings), and I think it's going to do that whether the Fed moves or not," he said. "The quicker they get into that mode the better the Fed is going to be down the road."