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. hui. This makes sense: the Fed's preference since the central bank started to raise interest rates in the near term at the end of 2015 was 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 hikes by the end of the year – and over the next few years. Recent data supports the idea that the Fed would increase its aid rates further than previously expected by the end of the year. That 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 this year. The policy range was expected to be around 3.25-3.5%, while the "longer term" assessment of the Fed 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 term the level at which it "should converge under appropriate monetary policy and make it sound". lack of appropriate monetary policy. "new shocks to the economy.")

That 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 most significantly, China's policy has shifted from austerity to reflation. This pushed up commodity prices, which affected 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 US corporate profits.

The latest Fed forecasts released by 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 this year and 2.75 to 3% by the end of 2019, which is higher than nadir expectations almost two years ago, but not much.

Market prices currently imply a larger tightening than predicted by the Fed:

This is unusual. Since the Fed started publishing its forecast on what it would do, traders have bet on the fact that the Fed would end up raising interest rates more slowly and less than politicians say .

One explanation 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 wait time 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-slim 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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