As we warned here exactly one month ago, the tapering discussion may be merely a “sideshow to a previously undiscussed main event: the Fed’s first forecast of 2016 interest rates.” Now, the Fed’s mouthpiece-at-large has decided we can handle the truth and the WSJ’s John Hilsenrath explains the dilemma – The Fed’s updated economic projections could show an economy that appears back to normal by 2016, but their projections of where short-term interest rates will be could show rates still quite low by then. Their challenge: How to justify the low interest-rate plan when their own estimates suggest an economy regaining its health. Crucially, Hilsenrath adds, as the economy improves, the Fed is trying to shift its emphasis from bond buying, which has uncertain costs and benefits, to the low-rate pledge. How will the Fed square an economy near full employment with a federal funds rate that remains historically low? “There is an inconsistency there,” said John Taylor – apparently confirming what Rick Santelli asked before – “What is the Fed afraid of?“
“The problem is that at the end of 2016 [the FOMC’s] economic forecasts may well show an economy that is close to full employment and price stability. Normally in that situation one would expect the fed funds rate to be close to neutral—which is somewhere close to 4%. However, their end-of-2015 forecasts have a funds rate forecast centered around 1%.
An end-of-2016 funds rate of 4%, which implies 300bp of tightening over the course of 2016, is well in excess of what the market is pricing in.…If the Fed presents a 2016 interest rate forecast that is well above the market’s expectations—and if the market takes any cue from the Fed—this could tighten financial conditions such that the forecasted acceleration in growth fails to materialize“
and today via WSJ,
Federal Reserve officials face a communication challenge explaining their interest-rate plans when they gather for a policy meeting this week.
Their updated economic projections could show an economy that appears back to normal by 2016, but their projections of where short-term interest rates will be could show rates still quite low by then. Their challenge: How to justify the low interest-rate plan when their own estimates suggest an economy regaining its health.
Explaining the path of rates far in the future will get more complicated when the Fed releases its 2016 forecasts for the first time on Wednesday. Those forecasts are likely to show an unemployment rate within the 5.2% to 6% range that officials believe is normal in the long run and an inflation rate near the Fed’s 2% target. The Fed’s most recent public forecast, made in June, showed the jobless rate right around 6% by the fourth quarter of 2015 and inflation near 2%.
Contrast the economic forecast with the Fed’s interest-rate forecasts. In the long run, Fed officials believe the federal funds rate—an overnight bank lending rate that they manage—should be around 4%. They consider that to be a “neutral” in the long run, a rate that leads neither to too much inflation nor too little.
But the latest official projections show Fed officials expect the federal funds rate to be about 1% by the end of 2015, rising by a small amount after the jobless rate dips below 6.5%. It looks unlikely that the Fed would aim for 4% by 2016. Mr. Bernanke has signaled that once the Fed starts raising rates, officials expect to proceed slowly.
How will the Fed square an economy near full employment with a federal funds rate that remains historically low?
“There is an inconsistency there,” said John Taylor
As we concluded previosuly…
Want to crash the Fed? Just turn off the default Circular option in their excel models.
As JPMorgan’s Mike Feroli adds, “In some ways the Fed is at risk of being a victim of its own success.”