Gauging the Fed’s Next Move
The Federal Reserve will almost certainly raise interest rates this year—but don’t count on it doing so at this week’s meeting.
Fed Chairman Jerome Powell
The prices of overnight index swaps imply there is a 98% chance the Federal Open Market Committee will leave its policy target unchanged today. This makes sense: The Fed’s revealed preference since the central bank began gradually lifting short-term interest rates at the end of 2015 has been to announce rate hikes only at meetings with press conferences and the publication of revised forecasts. This week’s meeting features neither.
The debate within markets is less about the timing of specific moves and more about the cumulative amount of interest rate increases between now and the end of the year—and over the next few years. Recent data support the view that the Fed will end up raising rates more by the end of this year than had previously been expected. That may not mean much over the longer run, however.
The Fed first released projections for the end of 2018 back in September 2015. Back then, the thought was that the tightening cycle would be mostly done by the end of this year. The policy band was expected to be around 3.25-3.5%, while the “longer run” estimate of the Fed’s target was around 3.5%. (This longer-run estimate is analogous to the “natural/neutral” rate, as described in a previous column. As the Fed describes it, longer run means the level it “would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy.”)
That proved to be overoptimistic. Over the next few months, fears of excessive policy tightening by both the Fed and the Chinese government led to turmoil in commodity, equity, and credit markets. By early 2016 there were even serious concerns about a U.S. recession, although it turned out that the damage had been confined to the energy and manufacturing sectors.
Pessimism peaked that summer shortly after the U.K. vote to leave the European Union. The Fed’s forecasts published in September 2016 revealed that policymakers thought U.S. short-term interest rates would be below 2% by the end of 2018 and below 2.75% by the end of 2019.
Much has changed since then. Perhaps most significantly, Chinese policy reversed from austerity to reflation. That boosted commodity prices, which flowed through to credit conditions and global demand for capital goods. At the same time, the long-awaited recovery in Europe finally began to appear in 2017, while dollar depreciation, household dissaving, and corporate tax cuts all boosted U.S. corporate earnings.
The Fed’s latest batch of publicly available forecasts was published in March. For the most part, they do not reflect the changed mood. Officials expected the policy band to be 2-2.25% by the end of this year and 2.75-3% by the end of 2019—higher than the nadir of expectations almost two years ago, but not by much.
Market prices currently imply more tightening than that Fed forecast:
This is unusual. Ever since the Fed began publishing its predictions about what it would do, traders bet that the Fed would end up raising interest rates more slowly and by less than what policymakers were saying.
One explanation is that the recent data have been stronger than what may have been expected a few months ago. After years of rising more slowly than the Fed would have liked, inflation is now in line with the central bank’s goal. Underlying wage and salary growth has also accelerated, although not necessarily enough to keep up with inflation. Finally, the surge in oil prices has buoyed inflation expectations.
The chart below breaks down the change in the median expectation by showing how the implied probabilities of different outcomes have changed:
Traders are betting that there is a greater than 50% chance that the upper bound of the Fed’s policy band will be at least 2.5%.
Longer-term bond yields tell a different story, however. The implied 10-year yield on Treasury inflation-protected securities starting 20 years from now is as low as it’s ever been:
Traders seem to be sanguine about budget deficits but ultrapessimistic on the longer-term growth outlook. While the Fed may have more room to tighten in the short term than it did a few months ago, the central bank is still limited by the economy’s underlying constraints.
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