Morgan Stanley: The Fed's Gotta Hike Rates Like It's 1999

The market still needs its hand held.

Janet Yellen Holds News Conference Following Federal Open Market Committee Meeting
Photographer: Pete Marovich/Bloomberg *** Local Caption *** Janet Yellen

Yeah hey, they say two thousand zero zero party over, oops, out of time/ So tonight I'm gonna party like it's nineteen ninety-nine - Prince, 1999

At some point—perhaps tomorrow—the near-zero interest rate party of the past seven years will come to an end. And like the Y2K bug at the turn of the millennium, there's no shortage of worries about the potential systemic risk stemming from liftoff.

But assuming Armageddon does not ensue, attention will immediately shift to judging what kind of rate-hike cycle this will be as the dust from the initial move settles.

For the Fed's part, there are two historical episodes monetary policymakers will be determined not to repeat: the tightening phases initiated in 1994 and 2004.

These rate-hike cycles sit on opposite ends of the spectrum. In 1994, the Fed's hike surprised the markets, sparking a selloff of bonds and stocks. In 2004, monetary policymakers began a highly telegraphed sequence of rate hikes that failed to bring about a tightening of financial conditions, and a housing bust was the end result.

Morgan Stanley strategists Guneet Dhingra and Matthew Hornbach write, a day before we're due to find out the Fed's decision, that the best road map for Yellen and her colleagues to follow was laid out in 1999.

Here's how they describe a time when both the central bank's policy rate and Ricky Martin's album sales were on the rise:

The Fed has articulated a data-dependent approach wherein the path of rates should depend on the evolution of both economic data and financial conditions—neither of which have a tendency to evolve in a predictable way. The implication, of course, is that the Fed could leave rates unchanged or hike by 25 basis points at various times in an unpredictable way. This is similar to how the Fed was on-hold at some meetings in 1999, but also hiked by 25 basis points and 50 basis points at other meetings in 1999.

While it's highly doubtful that members of the Federal Open Market Committee are glued to their Bloomberg terminals right now—waiting for the implied probability of a hike to pass a certain threshold—Dhingra and Hornbach believe that the market's positioning still matters to central bankers.

They write that the roughly 30 percent chance, as priced by the futures market, of liftoff on Thursday is probably too low for the Fed to go. The strategists assign a probability of just 10 percent to a September hike, stating that it would constitute a big surprise for the market if it occurred. Moreover, it wouldn't fit the 1999 model.

During that hiking cycle, the implied probability of the eventual move was at least 50 percent, priced in the day prior to the announcement:

Morgan Stanley

The 1999 cycle was also characterized by instances in which the implied odds of a hike gapped higher but grinded lower, observe the strategists. That is, the probability of a rate hike for a given meeting went up on an elevator, but came down on a staircase. Increased confidence that a rate hike was on the way is tied to not-too-subtle hints from the Federal Reserve on the evolution of monetary policy, according to Dhingra and Hornbach.

For instance, in the month before the 1999 tightening cycle started, the central bank's statement indicated that the FOMC had "adopted a directive that is tilted toward the possibility of a firming in the stance of monetary policy."

On the above chart, you can see that the implied probability of a hike jumped to 84 percent four weeks before liftoff in 1999 from 52 percent five weeks before the event, attributable to the signal provided in the statement. 

This raises the possibility that, if the Fed considers the need for a hike to be priced in as a prerequisite to action, monetary policymakers could condition investors for liftoff using more explicit language or seek to bolster the importance of their "dot plot" as a form of forward guidance.

The Federal Reserve will be wary of a rate hike that substantially magnifies the tightening of financial conditions that has already occurred since late August and unduly crimps U.S. growth prospects. But once a tightening phase begins, monetary policymakers will want to be sure their hikes have some bite. Although Janet Yellen's Fed has indicated plans to move rates higher gradually, the Fed chair and her second-in-command have warned markets that the glide higher won't be at the "measured pace" taken by former Fed Chairman Alan Greenspan in the mid-aughts.

As such, the 1999 playbook could serve as the Goldilocks approach to tightening that monetary policymakers are looking for.

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