Measuring the next move of the Fed

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The Federal Reserve will almost certainly raise interest rates this year, but do not plan to do so at this week's meeting.

The President of the Fed, Jerome Powell

Zach Gibson / Bloomberg

Day-to-day trading prices imply that there is a 98% chance that the Federal Open Market Committee will leave its policy objective unchanged today. . This makes sense: the Fed's preference since the central bank began to raise interest rates in the near term at the end of 2015 has been to announce rate hikes only in meetings with press and publication of revised forecasts. This week's meeting is neither one nor the other.

The debate in the markets is less about the timing of specific moves than about the cumulative amount of interest rate increases by the end of the year – and over the next few years. Recent data supports the idea that the Fed will raise its aid rates faster than expected at the end of the year. It may not mean much in the long run, though.

The first forecasts published by the Fed for the end of 2018 went back to September 2015. At the time, it was thought that the tightening cycle would be done for the most part by the end of the year. . The policy range was expected to be around 3.25-3.5%, while the "longer term" assessment of the Fed's target was around 3.5%. (This long-term estimate is analogous to the "natural / neutral" rate described in a previous column, which, as the Fed describes it, means in the long run the level at which it "should converge under an appropriate monetary policy and at the same time". lack of appropriate monetary policy. "new shocks to the economy.")

This turned out to be too optimistic. In the coming months, fears of an excessive tightening of monetary policy, both by the Fed and the Chinese government, have caused turmoil in commodity markets, equities and equity markets. credit. At the beginning of 2016, the recession in the United States even raised serious concerns, although it turned out that the damage had been limited to the energy and manufacturing sectors.

Pessimism culminated that summer, shortly after the United Kingdom voted in favor of leaving the European Union. The Fed's forecast released in September 2016 revealed that policymakers thought US short-term interest rates would be below 2% by the end of 2018 and below 2.75% by the end of the year. of 2019.

A lot has changed since then. Perhaps more significantly, Chinese policy has moved from austerity to reflation. This has pushed up commodity prices, which has impacted credit conditions and global demand for capital goods. At the same time, the long-awaited recovery in Europe finally began to emerge in 2017, while the depreciation of the dollar, household dissaving and corporate tax cuts all boosted the profits of US companies.

The latest Fed forecasts available to the public were published in March. For the most part, they do not reflect the change of mood. Officials expected the rate range to reach 2-2.25% by the end of the year and 2.75 to 3% by the end of 2019. , which is higher than the expectations nadir almost two years ago, but not much.

Market prices currently imply more tightening than the Fed's:

This is unusual. Since the Fed began to publish its forecasts on what it would do, traders have bet that the Fed would end up raising interest rates more slowly and less than what policymakers said.

One of the explanations is that the recent data has been stronger than what might have been expected a few months ago. After years of slower growth than the Fed wants, inflation is now in line with the central bank's target. The growth in underlying wages and salaries has also accelerated, but not necessarily enough to keep up with inflation. Finally, soaring oil prices boosted inflation expectations.

The graph below illustrates the evolution of the median expectancy by showing how the implicit probabilities of different outcomes have changed:

Traders bet that there is more than a 50% chance that the upper limit of the Fed's policy range is at least 2.5%.

However, long-term bond yields tell a different story. The 10-Year Implied Return on Inflation-Protected Treasuries in 20 Years is as Low as Ever:

Traders seem optimistic about budget deficits but ultra-pessimistic about long-term growth prospects. While the Fed may have more scope for short-term tightening than a few months ago, the central bank is still constrained by the underlying constraints of the economy.

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