By Thomas M. Toerpe, Senior Vice President, FX and Interest Rate Derivatives
Since 1990, the U.S. has had two major interest rate tightening cycles after a recession. The first started in February 1994, when the Federal Reserve's Federal Open Market Committee (FOMC) raised the fed funds rate from three percent to six percent in a year. The second came in June 2004, an increase from one percent to 5.25 percent over two years.
How will we know when the next tightening cycle is coming?
Previous monetary policy decisions were cloaked in mystery. Under Chairman Alan Greenspan, the FOMC’s press releases from the 1990s and mid-2000s were generally short and vague. Market participants were left to interpret subtle signals emanating from the Fed, such as Greenspan’s testimony to Congress in January 1994, a press release issued less than a week later, and a May 2004 FOMC statement.
Ben Bernanke’s Fed has been far more transparent. This partly reflects lessons learned from the last two cycles, especially 1994 when the central bank’s rapid and unexpected actions disrupted the financial markets. It is also necessary because of the unprecedented scope and scale of the Fed’s policy actions in the wake of the Great Recession. There are simply many more moving pieces that the Fed has to coordinate to unwind its monetary accommodation; in a globalized financial market, the risk of miscommunication is high.
Today, the central bank has dramatically expanded the ways it communicates with the public.
So with all this new information, what do we know about Fed policy and the future interest rate outlook?
The dual mandate
Job creation and low inflation are hallmarks of a healthy economy, so Congress has given the Federal Reserve two goals: “maximum sustainable employment” and “price stability.” The current Fed has translated these general goals into specific numerical targets: an unemployment rate below 6.5 percent and inflation of no more than 2.5 percent. The most recent FOMC statement on May 1 lays out these goals.
Of course, the Fed does not apply these benchmarks mindlessly. They gather anecdotal evidence from business leaders (the Beige Book) and look at a wide range of economic data.
Fed officials have developed a range of economic forecasts that they now publish to show explicitly what assumptions are driving their outlook. Market analysts can compare these to their own forecasts and make educated guesses on future policy. Here are the most recent forecasts:
|Change in Real GDP||2.3% to 2.8%||2.9% to 3.4%||2.9% to 3.7%|
|Prior forecast||2.3% to 3.0%||3.0% to 3.5%||3.0% to 3.7%|
|Unemployment Rate||7.4% to 7.5%||6.7% to 7.0%||6.0% to 6.5%|
|Prior forecast||7.4% to 7.7%||6.8% to 7.3%||6.0% to 6.6%|
|Inflation||1.3% to 1.7%||1.5% to 2.0%||1.7% to 2.0%|
|Prior forecast||1.3% to 2.0%||1.5% to 2.0%||1.7% to 2.0%|
|Core Inflation||1.5% to 1.6%||1.7% to 2.0%||1.8% to 2.1%|
|Prior forecast||1.6% to 1.9%||1.6% to 2.0%||1.8% to 2.0%|
Note that the current forecasts imply that the Fed expects to start raising short term rates in 2015. Longer term instruments are priced to reflect that expectation.
Historically, the Fed’s key policy tool has been to manage short-term interest rates, by buying and selling liquid instruments on the open market (the “Open Market” part of the FOMC). With rates near zero and the economy flirting at times with deflation, that policy tool lost much of its potency, so the Fed shifted its purchases toward longer term instruments to accomplish the same goal. It is currently buying $45 billion per month in U.S. Treasury bonds and $40 billion in mortgage-backed bonds.
The Fed has also been more transparent about how it will use other tools in its “toolkit” to slow down the economy if inflation becomes a risk. It has multiple ways to increase interest rates, discourage lending and cool down an overheated economy. These range from selling the long-term bonds in its portfolio to increasing the interest it pays on bank reserves. In fact, transparency itself is a valuable tool because the market reacts quickly to anticipated Fed actions — actions which the Fed can now credibly communicate to the markets and the wider public.
Using this information, we can sketch out the timing of a credible tightening program. Later this year, assuming continued healing in the economy, look for the Fed to announce a reduction and eventual elimination of new long-term bond purchases — and remember that five- to 10-year bond yields are likely to rise in anticipation of this. Next, the FOMC will change its forward guidance on the pace of increases in the overnight fed funds rate, with actual rate increases to begin in late 2014 or early 2015. Finally, the Fed will start selling its portfolio of long-term bonds over a three- to five-year period, completing the tightening cycle by the end of this decade.
This program is not set in stone. The Fed will certainly adjust what it does based on economic developments, but this framework should help you interpret what its future actions mean for the long-term interest rate outlook.
Information provided was deemed accurate as of June 24, 2013.
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