The Federal Reserve is indicating that it will raise interest rates four more times before the end of 2016, but traders in the financial markets don’t believe it. They’re expecting just two more hikes in the coming year. The Fed’s lack of believability on rates could complicate its job of steering the U.S. economy next year and beyond.
The Fed damaged its credibility over the past half-decade by repeatedly stating that it expected to raise interest rates, only to back down when stronger growth failed to materialize. Traders made easy profits by betting against the central bank, defying an old maxim on Wall Street—“Don’t fight the Fed.” Now Fed Chair Janet Yellen and the rest of the monetary policymakers have to persuade the financial markets that this time, they really, really mean it.
On Dec. 16 the rate-setting Federal Open Market Committee raised its target for the federal funds rate to a range of 0.25 percent to 0.5 percent from a range that touched zero, where it had been since December 2008. The increase signals that Fed rate-setters feel that the U.S. recovery, which began in June 2009, is finally strong enough that they can begin taking it off monetary life support. “The underlying health of the U.S. economy seems to be quite sound,” Yellen said at a press conference.
The Fed’s own expectations for rates are set out in the periodically released “dot plot.” Each dot in this chart represents a forecast for the fed funds rate by a member of the FOMC. The panel consists of the people on the Federal Reserve Board in Washington, currently five, and the presidents of the 12 regional Federal Reserve Banks. The committee members are asked to make forecasts for the end of each year. The identity of the person associated with each dot is not revealed. In the forecast that was released on Dec. 16, the median FOMC member—i.e., the one whose dot was in the center of the cluster—predicted a federal funds rate of 1.25 percent to 1.5 percent at the end of 2016. That amounts to four hikes, assuming each is a quarter point.
That range is significantly higher than what the market is expecting. The market is looking for the federal funds rate to be a little under 1 percent a year from now, says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. He bases his calculation on trading in the highly active eurodollar market, which traders use to bet on U.S. interest rates. (The federal funds rate is what big banks charge each other for overnight loans; pushing it higher affects a wide range of other rates.)
One reason for the gap between the Fed and the markets is purely mechanical: The Fed voters were instructed to pick the single most likely level for the interest rate, whereas the financial markets take into account the entire range of possible outcomes, including the chance of a recession in the coming year that would drag the rate down.
Beyond that, the gap shows that participants in the financial markets, correctly or not, don’t believe that the Fed will raise rates as fast as it says. To justify higher rates, the Fed will need to see stronger economic growth and a rise in the inflation rate, which is below the Fed’s target of 2 percent. Jacob Oubina, senior U.S. economist at RBC Capital Markets, thinks the market may be underestimating the Fed. “To agree with where the market sees rates for next year, you have to be pretty bearish about the prospects for growth in 2016,” he says. It’s common for the market to underestimate the pace at which the Fed will change interest rates, Oubina says. “I think this time it’s even more pronounced because of the length of time we have been near zero.”
Jan Hatzius, chief economist of Goldman Sachs, says the Fed’s forecast is probably better than the financial market’s. But he says the Fed rate-setters’ predictions may be a bit on the high side because they contain an element of wishful thinking. The rate-setters, after all, aren’t just observers; they’re policy-shapers. Their forecasts for the funds rate after 2018 are clustered at 3.25 percent to 3.5 percent. The end-of-2016 dots are just a step along the way to that. “It’s not just a pure forecast,” says Hatzius. “It’s about guiding expectations.”
It can be a real problem for the Fed when the market doesn’t believe it because, in monetary policy, expectations matter. Low interest rates in the market reflect low expectations for inflation and economic growth. Those expectations can be self-fulfilling—for example, businesses that don’t trust that growth is coming won’t hire and invest. In a Dec. 2 speech to the Economic Club of Washington, D.C., Yellen acknowledged that market measures of expected inflation had fallen to “historically low levels” this fall. She said that while she’s not greatly worried at the moment, “declines in consumer and business expectations about inflation could put downward pressure on actual inflation.” The danger of losing control of monetary policy is obvious in Europe. The European Central Bank wants the refinancing rate to be 0.05 percent, but it’s actually −0.24 percent.
All that said, it looks as though the Fed does have the tools to get what it wants. The labor market has strengthened, and corporate balance sheets are stronger than they’ve been in decades. Worries about an emerging-market meltdown have eased slightly as the People’s Bank of China pumps money into the Chinese economy. It may be time to dust off that old maxim: Don’t fight the Fed.
The bottom line: The markets’ distrust of the Fed’s take on rates could complicate the central bank’s efforts to normalize monetary policy.