United States: Fed short-term rates projections revised significantly up
In line with expectations, the Fed decided yesterday to cut by another $10bn its monthly pace of asset buying (to $55bn), and gave a more ‘qualitative’ flavour to its forward guidance on interest rates.
The surprise came from Fed rate projections. They were revised significantly up, which contributed to pushing Treasury bond yields up.
The FOMC statement and press conference confirmed that the Fed remains upbeat on the economy and that there would have to be a barrage of further economic setbacks before it decided to call a halt to its QE3 tapering. Therefore, our scenario remains that the monthly pace of buying will be cut by $10bn at each FOMC meeting in 2014 (see chart above). This means that the asset purchase programme will end in October and will total $450bn in 2014, despite the tapering. This remains quite substantial: three-quarters of the size of QE2 and almost half of what was purchased in 2013 ($1,000bn).
Switch to a more qualitative forward guidance
Most forecasters, including us, were expecting a switch from a threshold-based interest rate forward guidance to a more qualitative form of guidance. This is what happened yesterday. The revised statement dropped the 6.5% unemployment threshold and stated that in determining how long to maintain its zero rate policy, “the Committee will assess progress – both realized and expected – toward its objectives of maximum employment and 2 per cent inflation”. It also emphasised that in its analysis the Fed will “take into account a wide range of information, including measures of labour market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments”. Regarding its current assessment of these factors, the FOMC considered that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase programme ends”.
Some additional guidance about what will happen after the first rate hike was added to the statement. The FOMC noted it anticipates that “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run”. This paragraph helps to explain why the FOMC rate forecasts remain well below the neutral estimate, even for 2016.
Fed funds rate projections revised up significantly
Importantly, Janet Yellen emphasised that yesterday’s change in the forward guidance on interest rates (described above) “does not indicate any change in the Committee’s policy intentions as set forth in its recent statements”. However, that’s not how financial markets read yesterday’s flow of information, for at least two reasons.
First, during the Q&A session, Ms Yellen was asked what she meant by a “considerable time” (see above). She answered that it “probably means something on the order of around six months or that type of thing”. Although, this remains pretty vague, it suggests that if QE ends in October, as is expected, a first rate hike might occur as early as around April, ahead of what was priced into futures before, i.e. July (see chart above).
Second, as usual at the end of the quarter, the Fed updated its set of projections. Without much surprise, GDP growth rates and unemployment rates were revised down. The surprise came from Fed funds rate projections. They were revised noticeably up. The median forecast for the end of 2015 was revised from 0.75% to 1.0% and the one for end-2016 from 1.75% to 2.25%.
These rate forecasts are strange animals. On one hand, they are nothing more than the aggregation of numerous forecasts (16 yesterday) from voting and non-voting Fed members. These projections can change pretty quickly and depend on who is attending the meeting. Moreover, for the end of 2016, the lowest projection was 0.75% and the highest 4.25%. This is a very wide range and therefore the meaning of the median (or mean) forecast is rather limited. On the other hand, Fed rate forecasts are more and more part of its forward guidance. Actually, with a more qualitative form of guidance in the statement, changes in Fed funds rate projections may have a strong impact on market anticipations, and that’s what happened yesterday.
The end result was that despite a relatively dovish FOMC statement, yesterday’s meeting was perceived as more hawkish than expected. Anticipations on Fed funds rates and effective long-term rates rose. On the basis of future contracts, pricing for the Fed funds rate by the end of 2016 rose by some 20 basis points to 1.8%. In just one day, this represents a significant upward move. Nevertheless, market expectations remain on the dovish side of Fed projections. Our view is that once economic growth regains some momentum and/or inflation inches higher, anticipations on Fed funds rate will also move higher.
In our view, our monetary policy forecasts remain basically unchanged. We continue to expect the Fed to cease purchasing assets by the end of October and the first rate hike to occur around mid-2015. Actually, this forecast has remained unchanged for more than one year. However, one important point is that these expectations are highly dependent on our relatively bullish growth scenario.
Regarding the path of the Fed funds rate after the first hike, we believe that even after yesterday’s upward move, future markets are still much too dovish. Obviously, with the Fed doing its best to distillate accommodative comments, inflation stable at low levels and high uncertainties around the underlying strength of the economy, this situation can last some more time. However, if we are right and economic growth picks up, inflation inches up and wage pressure accelerates somewhat, market anticipations around the future path of the Fed funds rate will increase substantially. Nevertheless, and although it should prove to be a difficult task, the Fed will do its utmost to prevent its exit strategy from causing an unwarranted steep spike in long-bond yields.