Article updated as of November 2014.

There are rarely any “sure things” in the financial markets, but the likelihood of a U.S. Federal Reserve rate increase in 2015 is fairly close – or at least that’s the conventional wisdom. At this point, however, it’s necessary to have a clear sense of the reasons why the Fed is likely to raise rates if it indeed goes through with its current plan.

The short answer: it needs to maintain credibility.


The Fed has telegraphed its intention to raise rates in 2015 for so long that barring an unforeseen event, it now needs to raise rates – at least by a small amount – in order for the markets to retain confidence in its statements. In turn, the Fed needs this confidence for its communications to have the intended effect. As a result, it would take extraordinary developments for the Fed to deviate from its current course, including a sudden and extreme loss of momentum in the U.S. economy, increased political instability overseas, or a similarly unexpected event.

Aside from this consideration, there is no actual need for the Fed to begin raising rates any time soon. In fact, there are three important reasons why it shouldn’t:

The Economy: U.S. economic growth has improved, but it remains below trend at this stage of the recovery, and labor force participation is at its lowest level since 1977 (as of October, 2014).

Inflation is Non-Existent: U.S inflation is running at just 1.7% per year (as of August, 2014), but this is only part of the story.

Currently, the disinflationary forces emanating from the overseas economies is threatening to keep domestic inflation well below the Fed’s 2.0% target for quite some time to come. Europe is the most important source of potential disinflation, as inflation in the region has fallen from 2% in January 2013 to 0.8% at the start of 2014 and 0.3% as of September 2014. This leaves the region perilously close to deflation, or falling prices.

While inflation in different regions can diverge in the short term, this represents an important drag on future U.S. inflation unless Europe can right the ship in short order. Not least, the precursors to higher inflation – wage pressures and peak capacity utilization – are absent. Commodity prices have also been exceptionally weak, which eliminates yet another potential source of higher inflation.

The Strong U.S. Dollar: While currency movements can reverse quickly, the exceptional strength in the U.S. dollar during 2014 argues against Fed action. Dollar strength cools economic growth and removes inflation pressure, so in effect the strong dollar can have the same end impact as Fed rate hikes. In short, the dollar is doing some of the Fed's dirty work for it.

Reassessing the Timeline

These factors indicate that the Fed, in theory, could wait to raise interest rates until 2016. Here, critics will make the argument that the Fed never should have cut rates this low in the first place, and the time to normalize policy (i.e., raise rates to more typical levels) is long past. That may be true in one sense, but it’s also important to consider that once the Fed begins to raise rates, it can’t backtrack (by cutting rates or re-initiating its quantitative easing policy) without scuttling its credibility. Conversely, it’s much easier for the Fed – or any central bank for that matter – to play “catch-up” by raising rates quickly if inflation starts rising more quickly than expected.

Put it all together, and there’s no reason to fear the Fed.

While it’s reasonable to expect a symbolic rate hike in 2015, this may not even occur until the autumn. Keep in mind that the Fed elected not to announce the “tapering” of its quantitative easing policy when the markets thought it would in October, 2013. Instead, it waited two months until its December meeting. In other words, there is a recent precedent for the Fed acting later than investors expect.

Even if the Fed does raise the fed funds rate to 0.25% from the current range of 0% - 0.25% next year, it may maintain the type of deliberate pace that won’t see it boost rates a second time until 2016. As a result, it’s entirely possible that rates won’t close 2015 that much higher than they are at present.

The Bottom Line

Barring any surprises, the Fed will probably raise rates in 2015. However, the move is likely to be largely symbolic rather than the beginning of a longer series of increases such as what occurred in 1994. Add it up, and Fed policy isn't likely to become a major factor for the financial markets anytime soon.