Fed expected to move closer to raising interest rates

Investors will be fixated on whether the Fed keeps one phrase in the announcement, namely that the central bank plans to keep short-term interest rates near zero for a “considerable time.”

In recent weeks, officials have signaled that the economy and the labor market might finally be improving fast enough to justify increasing rates in a matter of months.

Federal Reserve Bank of New York President William Dudley said as much in a Dec. 1 speech, noting that “market expectations that lift-off will occur around mid-2015 seem reasonable to me.” Investors currently expect the first rate increases then or later next year.

That timeline means economists are looking for the Fed to begin communicating its exit plans now, at one of the four meetings annually that includes a press conference from Yellen.

“The battle du jour is going to be the battle over ‘considerable time,’” said Michael Englund, chief economist for Action Economics.

“It seems from our standpoint that not removing ‘considerable time’ would be a dovish development,” Englund said. In central banking terms, doves are officials who are more eager to advocate loose money and less likely to be concerned about the threat of too-high inflation.

Fed officials might opt to replace the “considerable time” phrasing with a promise to be “patient” in raising rates, said Amherst Pierpoint chief economist Stephen Stanley.

The Fed used the term “patient” in the months preceding the beginning of its previous tightening cycle in mid-2004.

“I think a lot of folks, and I would put myself in that camp, feel like they would use that same playbook again,” said Stanley, noting that they could use other language to communicate that they will judge incoming economic data before making the final decision to raise rates.

Complicating the Fed’s analysis, however, is the recent drop in oil prices that raises risks to domestic producers and threatens to drag down inflation over coming months.

The price of U.S. crude has fallen by roughly half since June.

At the same time, expectations of inflation, as indicated by bond markets, have fallen rapidly. The difference between yields on five-year Treasury securities and yields on similarly-dated Treasury securities that are indexed to inflation fell Monday to the lowest level since 2010, when the Fed engaged in a round of large-scale bond purchases known as QE2 to boost the economy.

Thanks largely to the falling oil prices, inflation measures “are likely to run below 1 percent for most of next year,” HSBC economists Ryan Wang and Kevin Logan wrote in a research note Monday.

In addition to low unemployment, the Fed targets stable inflation at 2 percent.

Nevertheless, Fed officials will view the plunging prices of energy as a temporary impact on inflation and a boon to the economy, said BNP Paribas senior economist Bricklin Dwyer.

“They’re taking note of that, but they’re not quite worried yet,” Dwyer said of oil’s effect on inflation. “They’re worried about prices dropping that are reflective of a weaker economy. That’s not what we’re seeing,” Dwyer added.

Instead, prices other than energy and food rose from 1.5 percent to 1.6 percent since the Fed’s October meeting, according to the Personal Consumption Expenditures index compiled by the Bureau of Economic Analysis, the Fed’s preferred inflation gauge.

The Fed also prefers to look at survey-based measures of inflation expectations, rather than bond prices. Surveys, including the University of Michigan survey of consumers, have shown stable long-term inflation expectations.

The Fed will be “willing to look past the impact that the drop in oil prices is going to have on the headline inflation numbers in the near term,” Stanley said. He added that the committee might hesitate to raise rates if inflation is low and falling, but for now the Fed officials are just considering removing the “considerable time” language, not actually raising rates.