Calmer markets, positive data prime Fed to push ahead with rate rises

Barely a month ago Federal Reserve Chair Janet Yellen cut an isolated figure in her semi-annual testimony to Congress, forced to defend the U.S. central bank's data-dependent approach while around her stocks plunged and oil prices sagged.

But a recent string of positive economic news has dragged markets back closer to the Fed's overall outlook, allaying recession fears and suggesting the Fed will have more credibility at its meeting next week when it says further rate hikes this year remain firmly on the table.

"Financial markets for a while were completely out in the weeds, running around looking at things that turned out not to be real risk," said Torsten Slok, chief international economist at Deutsche Bank.

Janet Yellen
Getty Images

When the Fed raised its benchmark interest rate in December for the first time in a decade from near zero, its so-called "dot plot" of policymakers' forecasts penciled in four quarter-point hikes this year. Markets at the time priced in three increases.

Fed policymakers meet on March 15-16. They are expected to hold interest rates steady and are seen likely nudging down their expectations to three hikes for 2016.

As recently as two weeks ago, investors and traders had priced out any rate rise this year. They currently expect one, according to an analysis of fed funds futures by the CME Group.

Markets bounce back

The S&P 500 dropped almost 10 percent from January through mid-February on fears over China's rebalancing, a global growth slowdown and low oil prices. The rout risked having a sustained negative impact on the U.S. economy by tightening financial conditions.

Shipping containers being stacked in cargo dock
US import prices fell 0.3% in Feb vs 0.6% drop expected

Those worries have begun to fade. The United States added 242,000 jobs last month, far more than expected and the unemployment rate stands at 4.9 percent, near full employment. A total of 14.3 million private-sector jobs have been created since 2010.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, has also strengthened, posting for January its largest gain in 10 months.

Since hitting its lowest level in two years on Feb. 11, the S&P 500 has risen 9.5 percent, while the 10-year Treasury yield has risen about 35 basis points to 1.90 percent early Thursday.

Other market measures also suggest improved investor views on inflation and risk appetite. Their inflation outlook five years from now reached 1.70 percent last week, the highest level since January before easing to 1.59 percent this week.

The risk premium on junk bonds over Treasuries shrank nearly 150 basis points this week to just over 7 percent, which was a two-month low, according to an index compiled by Bank of America Merrill Lynch.

Brent crude oil has jumped to around $40 a barrel, up 45 percent from 12-year lows less than two months ago.

'Not one and done'

Fed policymakers have been banking in part on the effects of oil price declines to dissipate, helping inflation move back toward the central bank's 2-percent target rate as input costs trend higher.

The Fed said in December that future rate hikes were contingent on actual progress on inflation, which has been below target for the past four years. Core inflation jumped to 1.7 percent in the 12 months to January, the biggest rise since July 2014.

At the last meeting in January, the Fed took the unusual step of pulling its risk assessment of the economy in its statement. Next week's meeting could see a return, Fed watchers say.

In light of progress on inflation, the statement may also reflect the Fed's desire not to get too far behind the curve.

"I do think that they want to signal to markets that it's not over," said Standard & Poor's U.S. chief economist Beth Ann Bovino. "It's not a 'one and done' which had been talked about."