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The Fed will likely raise rates twice this year

Federal Reserve Board Chair Janet Yellen.
Getty Images
Federal Reserve Board Chair Janet Yellen.

Despite the recent weak labor report, the Federal Reserve still appears on course to raise interest rates relatively soon. Economic data on jobs, wages, and inflation, as well as financial market conditions, will influence the Fed's decision.

We think it is unlikely that the Fed will raise rates this month but we expect two rate hikes of a quarter percentage point each this – in September and December.

Federal Reserve Chair Janet Yellen recently clarified her thinking on the economy and the outlook for Fed policy following the surprisingly weak labor report, which showed payroll growth in May slowing to its lowest level since 2010. While Yellen called this "concerning" and repeatedly noted the uncertainty in the economic outlook, overall she was cautiously optimistic. In our view, if the incoming data are reasonably good, then the Fed will be hiking rates in the not-too-distant future.

When thinking about monetary policy, it's important to focus on the Fed's dual mandate: maximum employment and price stability, where stability is defined as a 2-percent inflation rate. Yellen stated, "I believe we are now close to eliminating the slack that has weighed on the labor market since the recession," and "I expect inflation to move back to 2 percent" as the impact of lower oil prices and the strong dollar fades. The big picture, then, is that the Fed is still on track to fulfilling its mandate.

Further, Yellen repeated previous comments that the "neutral" federal-funds rate is around 1 percentage point above the current rate, and that it would likely rise over time. Yellen has also said many times in the past that she wants to hike rates at a gradual pace. Given that they are already well below neutral and the Fed is very close to fulfilling its mandate, we can only conclude that the Fed will want to raise rates in the months ahead unless bad news obstructs that path.

However, before hiking again, Yellen will want to verify that the payroll slowdown seen in May is only temporary. This probably rules out a June hike, and also makes July unlikely, since there will only be one more labor report released before the July Federal Open Market Committee meeting. By the time of the September meeting, there will be three more labor reports, which should be sufficient to justify a hike as long as payrolls grow fast enough to diminish labor market slack further.

Based on Yellen's previous comments on the relationship between population growth and labor supply, something above 100,000 new jobs per month should suffice. Of course, other economic data, especially on inflation and wage growth, as well as financial market conditions, will also influence the Fed's decision.

We think that even mediocre data would be enough for the Fed to hike in September. A July hike is still possible if the economic data between now and the meeting are very strong. In either case, another hike should follow in December, as long as the economic recovery remains on track.

We recognize that Fed officials may struggle to communicate this without disrupting markets. Still, we believe risk assets can continue their recent improved performance. We maintain an overweight on U.S. equities, given our expectation for bottom-line growth to recover. We are underweight U.S. government bonds, which we expect to produce a modest negative return over the coming six months, as markets adjust to a somewhat faster pace of rate hikes by the Fed.

Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $2 trillion in invested assets. Follow him on LinkedIn at www.linkedin.com/in/markhaefele.

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