Why analysts expect a gradual pace for the federal funds rate
Must-read: The rate rise timeline you should watch for now (Part 5 of 5)
After lift-off, the Fed will likely normalize rates slowly until we reach a federal funds rate closer to 3%. The pace at which the Fed normalizes the rate will most likely be very deliberate, and much slower than any exit strategy (rate hiking cycle) in the past. I also expect that the destination of ultimate rate policy is to a neutral federal funds rate that will be lower than the 4% it has been at historically, i.e. closer to a 3% neutral federal funds rate.
Market Realist – The graph above shows the opinions of each member of the Federal Open Market Committee (or FOMC) as to what the federal funds rate should be in 2014, 2015, and 2016.
Most members expect the appropriate federal funds rate to be between 1% and 2% next year. Most members estimate the appropriate rate to be 2% to 3% in 2016.
In short, we’re at the beginning of a sooner-than-expected, and very significant, period of transition for Fed monetary policy, and given today’s slow economic growth, the path toward normalizing rates is likely to involve a slower pace and a well-defined lower rate destination than past exits.
As for what this means for markets and the economy, news of a rate rise plan could disrupt markets in the near term, but I don’t expect to see another market reaction like the 2013 “taper tantrum” following the Fed’s taper announcement.
Market Realist – In May of last year, the market (SPY) expected the Fed to downgrade the outlook of the U.S. economy due to the sluggish labor market and slow economic growth. However, the Fed chose to upgrade the outlook for economic risks and introduce a taper of the bond buying program. This surprised the markets (IVV) and led to an aggressive routing of both stock (SPY)(IVV) and bond (BND) markets—often called the “taper tantrum.” Since market expectations for the U.S. economy are largely upbeat now, a vehement upheaval in the markets is unlikely.
Rather, assuming the Fed clearly lays out its transition plan and key metrics and articulates that this exit strategy won’t look like the rapid ones of the past, the long-end of the interest rate curve should move up only modestly and remain relatively stable in coming months as the yield curve flattens, and markets should be able to adjust fairly smoothly.
In addition, a well-articulated Fed plan for normalizing rates at a slower pace and with a lower destination rate than past exits is likely to imbue corporations and other economic actors with more confidence in the future. As a result, they may engage in more long-term spending and investment decisions going forward, and capital spending, housing, and investment may move forward. This, in turn, should ultimately benefit the economy and markets.
Market Realist – Read our series on hedging against rising interest rates to learn how you can protect your portfolio during a rising rate environment.
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