When Will the FOMC Tighten the Fed Funds Rate? by David Merkel, CFA of The Aleph Blog
There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better. Don’t assume the FOMC:
- Shares your view of how economies work.
- Cares about the politics of the situation.
- Knows what it really wants, aside from magic.
- Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
- Cares about the reasoning of dissenters on the committee.
- Understands what is actually happening in the economy, much less what its policy tools will really do.
But you can assume the FOMC:
- Cares about the health of the banks, at least under extreme conditions
- Wants to do something good, even if their minds are poisoned by neoclassical economics
- Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact desired on the markets and economy.
- Will act in the manner that most protects its continued existence and privileges.
So if we want to guess when the FOMC will tighten, we can do three things:
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- Look at market opinion
- Look at the FOMC’s own opinions, or
- Something else
Let’s start with market opinion. At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter. Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well. So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.
Okay, so what does the FOMC think? Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:
In general, they have been overly optimistic about growth in the US economy. They probably still are too optimistic.
They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.
In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.
And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market. Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be. Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015? since September 2012. The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.
So, where does this leave us, but with a view that the FOMC will tighten policy next year. But what if the monetary doves on the FOMC remain dominant? After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate. That leaves me with this, which reflects the influence of the doves better:
This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.
The drift has happened because the economy has not strengthened the way the FOMC expected it would. If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected. After all, labor conditions are soft, and inflation as they measure it is not roaring ahead. (Please ignore the asset price inflation that aids the non-existent wealth effect.)
As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE. They are still waiting for their grand sign to act on Fed funds, and it has not come yet.
Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015. Prior expectations of FOMC action have signaled much earlier action than what has actually happened. From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus earlier than then. The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.