Recent events and news in financial markets suggest that the long wait for the start of a US rate-hike cycle could be longer than initially anticipated. And we all know how short delays can quickly become long delays…….
In this post we provide background information on the policy choice facing the Federal Reserve with regard to an increase in official interest rates and the current outlook.
In October 2014 the US Federal Reserve brought an end to their programme of quantitative easing – the biggest emergency economic stimulus in history – which added more than USD 3.5 trillion to the Fed’s balance sheet.
The next step in normalising market conditions is for the Fed is to begin raising policy rates from their current levels of near zero. If the Federal Reserve were to raise US interest rates in 2015 it would signal the “progress the economy has made in healing from the trauma of the financial crisis” said Fed chair Janet Yellen in testimony to the House Financial Services Committee of the US Congress on 15 July 2015.
A rate hike from the Fed would potentially signal a major turning point..
A hike in official interest rates by the US Federal Reserve would be the first change in offical rates since 2006 and the first hike by the Fed since June 2004. Members of the Federal Reserve have themselves warned that such a prolonged period of low interest rates may have created incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to “reach for yield.” There is therefore some trepidation as what will happen when the Fed brings an end to this long period of ultra-low interest rates.
On 15 December 2006 the US Federal Reserve cut the federal funds target rate, its principal policy rate, by 75bp to a range of zero to 0.25%. It has remained at this level since – 8 ½ years of a close-to-zero federal funds rate – an unprecedentedly long period without change in the last twenty years (see exhibit 1 below).
Exhibit 1: Changes in the federal funds rate during the period between June 1995 and June 2015
In recent months the Fed has painstakingly prepared markets for higher interest rates, justified by positive expectations for output, inflation and the US labour market in 2015 – 2016. Fed chair Janet L. Yellen left the door open to a rate hike even as early as September 2015 in her Testimony before Congress on 15 July 2015.
The Fed seeks to engineer a smooth take-off…
Nonetheless there are risks to hiking interest rates, policy makers do not want to raise interest rate too soon.
“History has not looked kindly on attempts to prematurely remove monetary accommodation from economies that are in or near a liquidity trap,” said Federal Reserve Bank of Chicago President Charles Evans said in a speech last year. He went on to outline the scenario policymakers are at pains to avoid :
“If we were to presume prematurely that the U.S. economy has returned to a more business-as-usual position and reduce monetary accommodation too soon, we could find ourselves in the very uncomfortable position” of having just raised rates off of near-zero levels, having to lower them in short order.
For this reason the Fed has insisted that they will only raise policy rates when they have a great deal of confidence economic growth has enough momentum to reach full employment and that inflation will return to a sustainable 2% rate.
Members of the Federal Reserve have gone to considerable trouble to reassure markets that they will proceed cautiously and keep the path of rate increases relatively shallow for some time after they begin to raise rates to ensure that the economy is well enough to deal with the rate increases.
At the quarterly press conference following the FOMC meeting on June 17, Janet Yellen, the Fed’s chairwoman, advised us to focus less on when the first rate hike occurs (September, December 2015 or March 2016) and more on the fact that the pace of rate hikes will be gradual. Her insistance on the word ‘gradual’ is such that Fed-watchers now measure the number of times she can use the word in an hour during her press conferences. In June 2015 Stanley Fischer, Fed vice-chairman, said that « lift-off » was the wrong word for rate rises when they came, insisting that the central bank would be « crawling » as it pursued incremental increases. On 15 July 2015 Fed chair Yellen argued that hiking rates earlier rather than later would facilitate their pursuit of a “shallow path” of rate hikes.
There is considerable speculation as to when the Federal Reserve will begin hiking rates. The most recent meeting of the Federal Open Market Committee (FOMC) on 29/07/15 gave no strong hints as whether a rate hike is imminent but theoretically it remains possible that the Fed hikes rate in either September or December 2015. The decision, the Fed has said, will be “data-dependent.”
Exhibit 2: There have been five cycles of rate hikes by the Federal Reserve since 1980 (click directly on the graph to enlarge):
The dot plot whatnot….
Since 2012 the Fed has published a ‘dot plot’ in their Summary of Economic Projections. The dot plot is a chart that shows the expectations of each FOMC member — anonymously — as to where the central bank’s overnight lending rate will be in the future.
Exhibit 3 below shows the dot plot following the most recent meeting of the Federal Open Markets Committee in June 2015. The median projection of where policy makers think the federal funds rate will end the year 2015 has slipped downwards over over the course of 2015 through June.
The latest dot plot shows that all 17 members of the FOMC expect that the appropriate federal funds rate for the end of 2015 should be under 1%, with the median member seeing rates between 0.5% and 0.75%. That would appear to signal an end to zero interest rate policy, so rate hike(s) later this year are still on the cards.
On 29 July 2015 the FOMC meeting did not include economic projections, policy dot plots, or a prescheduled press briefing. However the wording of the policy statement published after the meeting could, potentially, have been very significant. If the FOMC had intended to hike in September it could have altered its forward guidance to prepare the markets explicitly for a near-term rate hike. There are clear precedents for such a language change – immediately prior to the start of its two previous tightening cycles (1999-2000 and 2004 -2006) strong hints about imminent tightening moves were part of the the FOMC’s policy statements.
In the event the policy statement published on 30 July 2015 did not give an explicit steer on the timing of a possible rate hike. The statement points towards a readiness for rate hiking albeit not pre-determined and highly data dependent.
Events over the course of the summer appear to have lowered the probability of a Fed rate hike in September 2015. Among the factors that could lead the Federal Reserve to postpone a rate hike until December 2015, or even until to 2016, we would cite the following:
- The sell-off in global stock markets has clouded the outlook for a US interest rate rise. This was acknowledged on 26/08/15 by New York Federal Reserve President William Dudley who said that “At this moment, the decision to begin the normalisation process at the September FOMC meeting seems less compelling to me than it was a few weeks ago.“
- US inflation data is consistently subdued. The annual rate of consumer price inflation is running at less than 1% currently, well below the Fed’s 2% target for inflation. Prices of more than half the components of the consumer price index have fallen in the last six months – the first time this has happened in more than a decade. Market-based measures of expectations suggest that, over the next ten years, inflation will be well under 2%. Events in China and falling oil prices are creating new disinflationary pressures.
Prior to the Fed’s meeting on 29/07/15, the Fed funds futures strip implied a slightly lower than 50% probability of a rate hike in September. In the intervening period the implied probability of a rate hike in September has fallen to 25%.
Exhibit 3: FOMC dot plot, target federal funds rate at year-end, published June 2015 (click directly on the graph to enlarge).
Source: Bloomberg, BNPP IP
In the opinion of our Multi Asset Solutions (MAS) team, the Fed will hike this September
According to market indicators developed to measure the number of months before the first rate hike in the US, market-based expectations have been pushed back lately. In our view there are several factors at play here.
Firstly, there is the recent uncertainty about developments in China. The recent turmoil in markets and the resulting appreciation of the US dollar could keep the Fed from hiking in September. We await further economic data before reassessing our call for a hike in September. If US domestic economic progress remains strong, the Fed could still go ahead. Given that a hike could in any case cause some market volatility, postponing it could raise uncertainty about the underlying strength of the US economy.
Thus, while it is conceivable that international developments delay the coming Fed rate hike, we do not see any domestic reasons for the Fed to wait. In our view the Fed will ignore the IMF’s repeated warnings to hold off on policy tightening until next year. Of course, inflation is currently below the Fed’s preferred level, but it would seem that the Fed is keen to get the process of normalising interest rates underway.