On Wednesday, the Federal Reserve convened its regular FOMC meeting to discuss monetary policy and the state of the economy. These meetings are highly anticipated by the finance world, and rightly so. At these meetings, the chair of the Federal Reserve gives her thoughts on the economy and, some hope, an indication as to what interest rate policy will be in the coming months.
This particular meeting was interesting in that expectations for a rate hike had generally been high this year. Earlier this year, many expected a hike in the Federal Funds Rate (FFR) by mid-year. After this meeting, likely very few hold this position. Chair Yellen essentially indicated that a rate hike may come by the end of the year but that upward movement in the FFR target will be slower than originally anticipated.
Yellen has indicated before that monetary policy is "data dependent," so the slower-than-anticipated rate hikes imply that Yellen is not happy with the employment and inflation data/forecasts. The employment aspect of this is especially complicated, since we know that labor force participation has fallen and continues to fall, and many still remain underemployed.
The Atlanta Fed's GDP Now forecast for 2nd quarter GDP has strengthened dramatically since early June. To get anywhere close to the Fed's original annual growth forecast, 2nd, 3rd, and 4th quarter GDP growth is going to have to offset the -0.7% decline in GDP in the 1st quarter. Slow GDP growth also provides justification for low rates.
To get a better perspective on the unprecedented level of accommodation the Fed has provided since the financial crisis, we need to look at the money multiplier (Graph 1). The dramatic increase in the monetary base and decline in the money multiplier (ratio of M2 to base money) are, in my view, an indication of demand- and supply- side problems and other Fed policy. On the demand side, I think there's a general unwillingness to increase leverage and only marginal improvements are occurring in both business and consumer credit markets.
Supply side factors include bank risk aversion, which is probably improving somewhat and the Fed's policy of paying interest on reserves. These two conditions combine to lower the willingness to lend, resulting in a low money multiplier. This has probably kept inflation at bay.
So, market interest rates are low because 1) consumers and businesses have relatively low demand for loans, due to depressed conditions in the "real sector"and the fact that they recently deleveraged, and 2) the Fed has continued to grow its already enormous balance sheet. This has kept asset markets prices strong but has likely prevented the "real sector" from liquidating malinvestments and reorienting production toward projects that are sustainable given conditions in the "real economy" (i.e. the availability of resources and preferences).
So when will the Fed raise rates? I think they have a pretty delicate balance to hit right now. They have to remain credible that a rate hike will come, but upward movement in the FFR target that the markets don't suspect could be a serious problem for asset markets. Graph 2 shows projections through June of next year for the FFR target. This information comes from CME's FedWatch tool which uses interest rate market information to calculate probabilities of FFR rate hikes.
The blue line below (left axis) shows the implied probability of a rate hike going forward. It doesn't cross the 50% line until December of this year, which makes me think a September or October hike isn't going to happen. I also think it's likely that we won't see any kind of rate hike until next year. The green bars (right axis) and red line (left axis) show the most likely target rates and the probability we'll see a given target rate, respectively. For instance, the most likely target rate for January 2016 is 0.5% and there's a roughly 35% probability the Fed will adjust the target rate to 0.5%. If you click the FedWatch link above, you'll see the other potential rates for each period. The possible target rates go up to 1% this year and as high as 2% in 2016.
Ultimately, I think the biggest constraint on pushing rates higher are 1) demand for credit and 2) the Federal government's ability to pay the interest expense on its debt. If the real economy isn't strong (and I don't think it really is all that strong), then demand for loans might continue to stay low. If raising rates too high will jeopardize the gov'ts ability to meet its obligations, the FFR is going to rise slowly. We won't see the 5% we saw in the mid '00s for a long time.
Acknowledgement: In writing this post, I benefited greatly from a discussion with Julien Noizet at Spontaneous Finance. Please visit his blog!