FED should not rush rate hike – Auto-tightening and multiplier edition

While traders and economists around the world remain cautious trying to gauge the exact time of first rate hike by US Federal Reserve, officials at FED are looking at hard evidence to justify first rate hike.

Current Federal Funds rate at 0-1/4 percent seems too low and a rate hike by ¼ percentage point might not make a difference according to many.

It is true that 25 basis points hike of Federal funds rate is minuscule, however the impact is definitely not.

• FED has not even tightened yet, just wind up the asset purchases. Still maintaining about $4 trillion balance sheet.
  
  
• Even then US 2 year treasury has yield has tightened from 0.3% in October last year, when the purchase ended to 0.7% by March 2015.
  
  
• FOMC got back into damage control mode to reduce excessive speculation and volatility and rates have now eased but still higher at 0.6%.

This results in auto- tightening in all sectors across United States.

AAA rated corporate bond rates go up automatically, which trades with a spread above treasury. Tightening will be higher for lower rated corporate bonds.

This multiplying effect will get vivified as rate hike environment will deeply entrenched in psychology. FED is not expected to move backwards once they start tightening (though they surely can but throws doubt on its credibility).

Speculation of further rate hike would have a multiplying effect on rates, which has the potential to derail recovery.

Forward guidance will be an effective tool to diminish such effects.

Lessons from prior rate hike -

• US yields have outpaced federal fund rate initially especially the short term rates. It has taken some time for FED to close in on the gap, as shown in the chart.

So even if that effect gets somewhat nullified, question comes what evidence is there for FED to move ahead?