Market analysts these days are obsessing over when the Federal Reserve will start raising interest rates, but the more important issue is where rates end-up once Yellen & Company finish “normalizing” the Fed Funds rate, whenever that might be.
Fed officials have made it clear that they expect to begin raising short-term interest rates from near-zero sometime in the second half of this year. And the Fed has made public where it thinks rates should go over the next few years of normalization. I’ll show you the Fed’s targets below.
Remember that the Fed Funds rate is near zero and has been since 2009.
The interesting thing, however, is that the interest rate futures markets are suggesting that rates will go up only about half as much as the Fed’s own projections over the next few years.
This disconnect between the Fed’s targets and what the markets think will happen over the next few years could be a source of market turbulence in the months ahead. Let’s look at the numbers.
The Fed’s short-term interest rate targets are as follows: 1.13% or higher by year-end 2015; 2.50% for the end of 2016 and 3.63% for the end of 2017.
On the other hand, in the Fed Funds futures markets, where traders buy and sell contracts based on expected rates, the Fed Funds rate is at: 0.50% for the end of 2015; 1.35% for the end of 2016; and 1.84% for the end of 2017.
That’s around half the Fed’s targets. So what gives? The obvious reason is that investors don’t believe the Fed will be able to raise rates as much as it deems appropriate. With inflation dipping into negative territory in January, I think investors could be right.
After all, Fed Chairman Ben Bernanke wanted to start raising the Fed Funds rate back in 2012, but the markets revolted, so he backed off. And we have yet to see the first Fed interest hike, now over two years later. No wonder that the futures markets continue to project that interest rate hikes in the next few years will be around half the Fed’s published targets.
Clearly, either the Fed is correct or the markets are correct. As a futures guy for the last 38 years, I would not bet against the markets! That is not to say that the rates implied by the futures markets won’t rise in the months and years ahead – that will depend on how the economy responds to the first few rate hikes.
There are analysts who believe that the Fed will only be able to raise rates a few times, falling well short of its 2.50% target for 2016 and 3.63% for 2017. And some also believe that if the first few rate hikes negatively affect the economy, the Fed may have to retreat to near zero rates again.
This happened in Sweden after its central bank raised rates in 2010 and in Japan after 2006. In both cases, the central banks had to reverse course and cut rates after economic shocks and deflation pressures crippled their economies.
A survey by the New York Fed of Wall Street bond dealers in January showed they attached a 20% probability to US short-term rates returning to zero within two years after “liftoff.” A return to zero isn’t the Fed’s expected outcome, so it doesn’t show up in its rate forecasts.
Investors might have other doubts about the Fed – for example, that it won’t reach its 2% inflation target and will thus be forced to keep rates low, or that it won’t have the will to carry through on the rate increases it has telegraphed.
In theory, there is a long-run equilibrium interest rate where the Fed should be headed, and it increasingly looks like that balance is at levels below the Fed’s current targets shown above. Thus, the Fed needs to reconsider its normalization schedule at upcoming policy meetings.
Even Larry Summers – former Treasury Secretary, former president of Harvard University and a candidate for Fed Chairman in 2013 – believes the Fed’s rate targets are too high given that the economic recovery is still happening at a slow pace. Summers believes that what he called “secular stagnation” (slow growth) in the economy will continue for some time.
Given all the uncertainties about growth and inflation/deflation, Fed officials may have to feel around like a person in the dark for the right interest rate targets.