With long-term U.S. bond yields rising and much of the recovery seemingly in place, analysts are increasingly wondering when the U.S. Federal Reserve (the Fed) will begin to implement its quantitative easing exit strategy and start raising interest rates.

Weekly Auctions of U.S. Treasuries Expected to Increase

Fed Rate Hikes Expected in September 2010; Earlier from Bank of Canada

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Analysts are unanimous in the expectation that the Fed will not and cannot raise rates in the first half of 2010, for a number of reasons, employment levels being the key one. The earliest we’ll see an increase is probably at the September meeting, even though the Fed is already beginning to talk about their exit strategies.

The outlook for the Bank of Canada, however, is quite different.  Ideally, Canada wouldn’t raise its rates in advance of the Fed, simply because of the effect it could have on Canadian exports.  But with stronger housing and employment numbers domestically in comparison with the U.S., it is increasingly looking like Canada will not have a choice and it could even be detrimental if Canada were to leave its rates as is past June 2010.

Some have even speculated about an interest rate increase in Canada prior to June 2010, but June, so far, is the consensus.

What’s the Possibility We See Double-Digit Inflation?

Increases in interest rates by central banks mean that it becomes more expensive to borrow money (auto financing and mortgage refinancing rates go up) and these increases are traditionally used to help slow down the rate of inflation when it occurs.  This time, the immediate concern is not with inflation (although the rising bond yields indicate the market is expecting inflation sooner rather than later), but with helping to stabilize the U.S. dollar, although these factors are all tightly interrelated.

The reason for the large drop in interest rates in 2008 was a lack of liquidity.  The crisis in third-party lending and counter-party risk meant that credit markets globally froze (U.S. financials’ reach went global) and the Fed stepped in to create excess liquidity and guarantee these counter-party relationships.  Without liquidity (the willingness of a lender to lend and a borrower to borrow; or the volume of buying and selling), the economy cannot function, since it is based upon the constant back-and-forth of buying and selling.

World Bank: Don’t Take USD Reserve Status for Granted

Of course, when interest rates go up, it will send important signals throughout the investment world in addition to the rise in borrowing costs for many homeowners.  Those with payment-option ARMs about to reset, in particular, may see increased payment amounts that many fear will result in more defaults.

The next meeting of the Federal Reserve is scheduled for January 27, 2010.  The Bank of Canada moves on January 19, 2010.

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Tagged as: central banks, Fed, Federal Reserve, fiscal policy, inflation, inflation control, interest rates, liquidity, monetary policy, raise interest rates, rate hikes, rising rates, U.S. Federal Reserve