USD: Will Yellen “split the baby” with a 0.125% hike?

<p>The Hebrew Bible tells the (likely apocryphal) tale of a two women who each claim to be the mother of an infant child. In order […]</p>

The Hebrew Bible tells the (likely apocryphal) tale of a two women who each claim to be the mother of an infant child. In order to resolve their maternal dispute, the women bring the baby to the wise King Solomon to determine the true mother. After a moment, Solomon calls for a sword and declares a “fair” solution: that the baby should be split in two, with each mother receiving one half of the child.

According to the tale, the true mother cried out for the baby to be given to the other woman, reasoning that a live child being raised by another woman was still better than a dead child. Reading between the lines, King Solomon realized that this woman must be the true mother and awarded custody of the child to her. To this day, the phrase “splitting the baby” is used to describe situations where a simple compromise is made between two competing legal claims.

Janet Yellen, a devout Jew, is no doubt familiar with the “Judgment of Solomon,” and as she heads into the biggest decision of her tenure as Chair of the Federal Reserve, the tale may subconsciously influence her thinking. To reset the stage, the market-implied odds of a 0.25% interest rate hike next week have been fading amidst financial market turmoil and fears of a slowdown in China, the world’s second-largest economy. Nonetheless, the Fed remains eager to raise interest rates and start the gradual process of normalizing monetary policy.

Rather than risk raising interest rates prematurely or falling behind the curve, Yellen and company may opt to “split the baby” by raising interest rates by only 12.5bps, from the current 0.00-0.25% range to a full 0.25%. After seven years of interest rates at essentially 0%, the “baby step” of a small rate hike may help smooth the transition into the tightening process and minimize any economic disturbance.

There is precedent for miniature rate hikes, as the Fed itself raised interest rates by less than a quarter-point under Alan Greenspan as recently as 1989, and many EM central banks (including Hungary’s National Bank) routinely tweak interest rates by as little as 0.10%. That said, some argue that such a move borders on hubris that a central bank can precisely control the trillions of transactions among volatile “animal spirits” that drive the US economy.

How Would a 0.125% Rate Hike Impact Markets?

Of course for traders, this theoretical discussion only matters to the extent that it impacts markets. For what it’s worth, Fed Funds futures contracts are currently pricing in just a 21% chance of a 25bps increase by next week, according to the CME’s FedWatch tool. Assuming this figure is accurate, it means that the “expected value” of the Fed’s decision is only about 5bps of tightening.

Therefore, a 12.5bps hike would be more hawkish than the market expects, with arguably less risk for market dislocation. If the Fed does opt for this nontraditional path, we would expect a knee-jerk rally in the US dollar, while equities and bonds could be vulnerable to modest weakness. This is by no means our base case, but it’s an under-the-radar possibility that’s definitely worth considering before next week’s big decision.

Regardless of what the Federal Reserve decides next week, it’s important to remember that the US central bank is still looking at tightening monetary policy, while almost every global central bank is still easing. While there will almost certainly be plenty of volatility in the immediate wake of the announcement, readers should be sure to keep this big-picture perspective in mind, like the true mother in the “Judgment of Solomon.”

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