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Are they wrong? Fed set to hike at a rough time

The Fed faces conditions that aren't exactly ideal as it heads into its potentially history-making rate decision later this week.

While there's never an ideal scenario for a rate hike, the conditions the U.S. central bank face are onerous. Declining oil prices are putting pressure on a number of fronts, not the least of which is a default scare in the junk bond market; corporate profits and manufacturing are at recessionary levels; and the economy is closing out another unspectacular year.

Moreover, things don't look any better on the international front.

The global war on terrorism is heating up, Europe's economy is struggling and the most of the Fed's global counterparts are taking the opposite approach, loosening rather than tightening monetary policy in an effort to promote growth.

Nevertheless, Wall Street is preparing for a quarter-point rate hike Wednesday that is seven years in the making.

The statement after the two-day Federal Open Market Committee meeting is "quite possibly the most highly anticipated policy announcement in memory," Lindsey M. Piegza, chief economist at Stifel Fixed Income, said in a note to clients.

In keeping with the gravity of the announcement, deliberations to get the Fed to move off zero, where it has been since late 2008, could be testy.

"As the committee contemplates the first rate increase since 2006, policymakers — particularly Chair (Janet) Yellen — will be struggling at the December meeting to convince colleagues in one direction or the other, reigning in hawkish expectations for more aggressive action while convincing the more dovish skeptics that a rate increase is appropriate regardless of the current restrained pace of economic expansion," Piegza added.

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On the hawkish side — or those who want to raise rates — will be a consistently improving jobs picture, albeit one that includes mediocre wage growth.

The unemployment rate has fallen to 5.0 percent and is expected to decline into the 4 percent range through 2016. However, the drop in the headline rate is in part a function of a labor force participation rate hovering around its lowest level since when Jimmy Carter was president. The actual rate of unemployment when factoring in those who have stopped looking for work or are underemployed is 9.9 percent.

On the inflation side, there also is scant impetus for a rate hike. The core personal consumption expenditures index that Yellen follows showed just a 1.3 percent annualized gain in its most recent reading and is expected to either hold steady or perhaps decline into the end of the year.

Pedestrians walk past the Federal Reserve building in Washington.
Andrew Harrer | Bloomberg | Getty Images
Pedestrians walk past the Federal Reserve building in Washington.

More broadly, economic growth has remained muted or worse. The most recent reading of the ISM manufacturing index indicated contraction in the sector, while GDP growth for the fourth quarter is expected to run at a 1.9 percent rate, according to the Atlanta Fed. Market data provider TrimTabs said its running gauge of economic conditions is at lowest level since mid-March.

What all the data points are likely to add up to is a Fed providing what many on Wall Street are terming a "dovish hike," or an increase that will be accompanied by certain language that the Fed will tread carefully in 2016.

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"Chair Yellen's press conference should offer a cautious message," Goldman Sachs economists Jan Hatzius and Zach Pandl said in a report for clients. "We expect her to underscore that policy is not on a preset course, and that the subsequent pace of rate hikes will be highly sensitive to incoming information — including data on activity and inflation, as well as financial conditions."

The Goldman duo believes that economic metrics are "broadly cooperating" with the Fed economic outlook.

However, what may in the end be the main driver of Fed policy is simple market expectations, with CME traders pricing in an 83 percent chance of a rate hike. The Fed backed off on a much-expected September rise at a time when traders lodged very low expectations for a hike, despite similar economic conditions to what is transpiring as the year comes to a close.

"We believe the future course of Fed policy depends mostly on how financial markets respond to the Fed's words and actions," David Santschi, CEO of TrimTabs, said in the narrative accompanying the firm's weekly market breakdown. "If stock prices rise into early next year, the Fed could raise rates a couple times next year. If stock prices keep heading lower, however, a rate hike this week is likely to be the last one for a while."

It's not just stock prices that have struggled.

While the S&P 500 has fallen more than 2.6 percent in December, the commodity wipeout continues. Natural gas has tumbled 51 percent year to date, copper is down 25 percent and gold is off 10 percent.

It's hardly the environment that screams for a rate hike to slow down an overheating economy.

"Modern central banking is as much an exercise in effective communication as it is economic analysis," Nick Colas, chief market strategist at Convergex, said in a note. "Something simple like 'We're going to raise rates' is fairly straightforward, even if it took the Fed the better part of a year to get it across to capital markets. Now, they must set the stage for future hikes."

Setting that stage in such a tenuous environment for the markets and economy will require a high level of skill.

Regardless, Colas thinks the markets at least will remain volatile. In the week heading into the Fed meeting, the CBOE Volatility Index, a popular gauge of market unease, has surged more than 48 percent.

"Yes, the market always climbs a wall of worry, and U.S. equities feel oversold at current levels. The point here is not that the end of the world is nigh as much as the world is getting incrementally complex in ways that don't get a lot of attention," Colas said. "All that is an argument for further volatility not just into holiday 2015 but well into the new year."