Thursday, 20 March 2014

Graph of the week: When will the Fed raise interest rates?

New Fed Chairwomen Janet Yellen held her first FOMC meeting this week where the committee members (7 members of the board plus 5 out of 12 Reserve bank presidents) gave their usual predictions on when the Fed could increase its target rate (federal funds rate) for the first time since December 2008 (it has been stuck at around 0.25% for the past 5 years). Investors in particular always listen closely to these meetings hoping to decipher a clear signal from the Fed on the long term expectations of the target rate. 

Source: WSJ
The conclusions from the meeting this week is that interest rate increases could start in the first half of 2015, or to be more precise around 6 months after the bond tapering program ends. Usually it was hard to get a concrete number from a Fed Chairman. Greenspan once said: "Since I have become a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said." However even though the statement said that rates are to remain near zero for a "considerable time" Yellen actually gave a number, defining considerable time as "probably around six months". For many investors this is as clear a signal as it gets. 

Anyway, as can be seen from the graph above the majority of the FOMC members will opt for a steady increase, where the rate is likely to still be below 1% in 2015, only to raise above it sometime in 2016. In the long run, naturally, they all expect a rate of around 3-4%. 

What kind of a signal is this for investors? The immediate market reaction was negative: interest rate expectations went up, while stocks fell. But this is all expected, as was expected that the Fed stimulus would eventually end.

On yesterday's meeting the Fed didn't link its interest rate and stimuli plans on any unemployment (or inflation) thresholds, as they did before. As you may or may not remember since the end of 2012 the Fed linked short term rates (and the bond tapering program) to the unemployment rate (it wasn't going to announce an increase of the target rate until unemployment fell to 6.5%). Since this is likely to happen sooner rather than later (in February the US unemployment rate was 6.7%), the end of the bond tapering program is expected, and so is the raise in interest rates. The investors will adjust to this information soon and I don't expect it to cause many problems. Even in the short run. 

In other projections they made, they expect economic growth to be around 3% this year, and slightly higher in 2015. Unemployment is predicted to go below 6% in 2015 (however, I doubt the E-P ratio will bounce back any time soon, as the economy is clearly on a new, lower, equilibrium output path). Inflation is still expected to be lower than 2% this year, between 1.4% and 1.6%. So the economy is recovering on a relatively stable growth trajectory, meaning that the FOMC announcements are absolutely realistic. Monetary policy was never intended to solve the US structural issues anyway. 

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