We all know the story about the boy who falsely cried wolf too many times that no one paid attention when the wolf really came and attached the sheep. So the question is – how do we know that this time the cry for rising rates is for real? Well, we don’t, but since this time the probability of rising rates is high, we better be ready.
Here is a simplified way to look at the probability of rising rates in 2015. The Fed, through its voting members, is faced with a dilemma. The U.S. economy is improving steadily, GDP is increasing mostly due to greater consumer consumption and the employment situation has greatly improved in the last few years. All in all, most of the vital signs of the U.S. economy are healthy and the economy can sustain a mild rise in short-term rates. Except, of course, for very low inflation rate caused mainly by low gas prices and flat wage level.
So the dilemma is – do you raise the funds rates based on the improving aspects of the economy with the hope that the dip in oil prices is going to be short lived and inflation will rise later on? Or, do you hold off on increasing the funds rate until inflation reaches the 2 percent mark thus delaying normalization for the longest time period in U.S. history? Based on the latest announcement from the FOMC and the new makeup of its voting members, there is a 75 percent chance that the funds rate will increase in June of this year, and a 25 percent chance that it will be delayed.
So, if you know that there is a high probability that the wolf is really coming this year; what do you do? You get ready.