Today’s signals from the Fed suggest that the central bank is still serious about raising rates around mid-2015, despite challenging market conditions and worries about low inflation.
After ending its QE programme in October the Fed today took another step towards the first rate hike. Thus, the central bank dropped its closely watched assurance that it will not raise rates for a “considerable time”, a pledge which has widely been considered a sign of no hikes for about six months. The Fed replaced it with a commitment to be patient in beginning to normalise interest rates.
Fed Chair Yellen did emphasise at the press conference that this change does not represent a change in the Fed’s policy intentions, repeating that the timing and pace of rate hikes remains firmly data dependent. She made it clear that the Fed won’t be raising rates in the first quarter of 2015: “In particular, the committee considers it unlikely to begin the normalization process for at least the next couple of meetings.”
Nonetheless, we see the removal of the pledge today as an important signal that the Fed still sees the first rate hike around mid-2015.
The “considerable time” phrase echoes similar language used in 2003 ahead of the most recent tightening cycle, when the Fed said it expected to keep rates low for a “considerable period”. The phrase was removed from the FOMC statement in January 2004, five months before the first rate hike in June, and replaced with a phrase saying that the Fed would be patient before raising rates, similar to the wording used today. A repetition of this old Greenspan template in the current cycle would place the first rate hike in May 2015.
We still expect lift-off in rates in June.
That a rate hike from the Fed is getting closer is also still suggested by the “dot plot”. The median FOMC projection for the funds rate was lowered a tad from 1.375% to 1.125% by end-2015, from 2.875% to 2.50% by end-2016 and from 3.75% to 3.625% by end-2017. However, given the 1.125% median FOMC projection for the fed funds rate by end-2015 and an assumed modest 25bp of tightening per FOMC meeting, this would place the first rate hike in July 2015, while the September projections pointed to lift-off in June.
Disconnect betwen markets and the Fed
Out of the 17 participants at today’s FOMC meeting, 15 expect that it will make sense to start raising rates in 2015. The other two participants do not expect lift-off until 2016.
Even with the Fed’s lowered fed funds rate forecast markets are still pricing in significantly less tightening than Fed officials project. Thus, currently the December 2016 fed funds futures contract prices in an implied fed funds rate of 1.47%, significantly below the 2.50% median FOMC projection by end-2016 (see chart). Only 4 of the 17 FOMC participants at today’s meeting expect a fed funds rate below 2% by end-2016.
Fed’s projections for the fed funds rate still point to lift-off around mid-2015
Expect more volatility as the Fed progresses toward policy normalisation
In our view, today’s key message to financial markets is that the Fed is primarily focused on the fact that the economy is fast approaching full employment, while monetary policy still remains in deep crisis mode. Overall economic indicators will therefore be decisive for the timing and pace of the normalisation of monetary policy.
While the Fed will keep an eye on financial markets, market participants should not expect the Fed to react to every decline in risk appetite as policy moves towards normalisation. Thus, the Fed will continue to look through short-term volatility and not respond to market concerns like the impact of the oil price drop on high-yield energy sector debt and energy-related equities unless it proves sufficient to conflict with the achievement of the Fed’s objectives. For now, the Fed seems confident that the sell-off in high-yield debt markets and equities is likely to remain contained to the energy sector, probably partly thanks to its regulatory or so-called macroprudential tools. Neither does the Fed seem overly concerned about the intensified economic turmoil in Russia at this juncture.
Moreover, the Fed continued to downplay the significance of the recent decline in headline inflation and market-based measures of inflation expectations, emphasising the temporary nature of the impact of lower oil prices and fairly stable survey-based expectations (see chart). Yellen said that she sees the plunge in oil prices as primarily good news for the US economy. The decline “is likely to be on net a positive,” she said. “In that sense it’s like a tax cut.” The drop in oil prices will put “downward pressure” on headline inflation and “may spill over to some extent to core inflation.” But overall, she said, the decline will likely be “transitory.”
With Fed officials and markets badly out of sync over the path of rates, we expect the central bank to take further verbal steps in coming months to shift market expectations closer to the Fed’s more hawkish forecasts for the fed funds rate.
As the date of lift-off in rates gets closer, market volatility is likely to rise. And once the Fed gives a clear signal that it is soon time for the first rate hike, we expect markets to start pricing in more rate hikes over the next few years.
That shift may imply a bumpy ride for markets. Our baseline scenario, however, remains that the Fed will be able control the economy with a gradual pace of rate hikes, but more aggressive tightening cannot be ruled out, considering the current large gap between market expectations and the FOMC’s fed fund rate forecasts for 2015-2017. In a recent speech New York Fed President Dudley suggested that in case markets do not react to potential Fed rate rises, rate hikes could need to come both earlier and faster.
FOMC economic projections (central tendencies)
Nordea