Federal Reserve Chair Janet Yellen's semi-annual monetary policy testimony to Congress this week was largely as expected, reiterating that rate hikes are more than likely this year. This reinforced the message in a speech she gave last Friday: Despite turmoil in China and Greece, and some uneven economic data (June retail sales, for instance), the Fed is preparing to raise interest rates in 2015 for the first time since 2006.
An expectation for two rate hikes by year-end has been baked into the Fed's Summary of Economic Projections, also known as the "dot plot," of individual policymakers for the last six months. And the consensus of Wall Street economists is that the Fed's September policy meeting will be the one for liftoff.
But the market is in denial: Goldman Sachs economist Jan Hatzius noted that swaps pricing suggests traders don't think the Fed will hike until December -- which is his base-case timing estimate. We'll know more when the Fed concludes its next two-day policy meeting on July 29.
Based on her latest comments, Yellen seems to be leaning toward a quick start in exchange for a more gradual pace of tightening instead of waiting too long and allowing wage inflation to take off, which would force the Fed to tighten more quickly. During the question and answer session with lawmakers, she said "we are close to where we want to be, and we now think that the economy cannot only tolerate but needs higher rates."
The exact timing will come down to whether or not wage inflation -- the final piece of the economic recovery -- materializes in a big way over the next two months. Before the September 17 policy meeting, the Fed will have two more monthly employment reports to base its decision on as well as the second-quarter GDP growth report and second-quarter employment cost report.
Michael Gapen at Barclays Capital is penciling in September for the first rate hike. He anticipates that the Fed "will view incoming data as convincing, if not decisive, evidence that the economy is sufficiently healthy to warrant moving away from the emergency levels of accommodation currently in place." But he admited his call "rests on a knife edge."
Kris Dawsey at Goldman Sachs pointed out that one of the reasons the market believes the Fed will wait until the very last minute to raise rates this year is that it has adopted a "we won't get fooled again" mentality after the Fed has repeatedly overestimated its own willingness to tighten policy.
Remember that Yellen last year ditched the 6.5 percent unemployment rate threshold that was established by her predecessor. The Fed also surprised the markets by holding off on starting the tapering of its QE3 bond-buying stimulus program until December 2013 instead of September that year.
Perhaps, two years later, another dovish surprise awaits investors this September.