How the Fed will determine when to hike interest rates - DailyFX Tips & Picks

IT WILL be an interesting week for those trying to figure out the Fed’s next move, and consequently for those trading dollars (as higher rates should increase demand for the greenback). Core personal consumption expenditures (PCE), non-farm payrolls, and the unemployment rate are all released. It’s these measures the Fed tries to control by raising or cutting rates.

Ideally, the unemployment rate would be at its long-term average, or what economists call NAIRU (non-accelerating inflation rate of unemployment). It’s when the most number of people are in work without causing a rise in inflation.

Inflation would occur if the demand for labour is higher than supply, which should happen if the economy is growing faster than its long-term pace. If the economy is allowed to grow above its potential for too long, we get bubbles. This is why economists are calling for Fed rate hikes.

The OECD estimated US NAIRU at 5.4 per cent by the end of 2014, and the unemployment rate is now 5.45 per cent. Further employment gains may therefore lead to higher inflation. If so, the Fed should hike rates later this year to avoid inflation problems in 2016.

While the relationship between unemployment and inflation is straightforward, not everyone is convinced that a rate hike will take place. The reason is that not all agree that the Fed is measuring inflation and unemployment correctly. This is where things become interesting for the trader. Will the Fed go ahead or not? If it does, history has shown that euro-dollar may decline between 500 to 700 pips in the three months ahead of a rate hike, and often stagnates after the fact.

Alejandro Zambrano is a currency strategy analyst at DailyFX.

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