When Oh When Is The Fed Likely To Begin 'Normalizing' Interest Rates?

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Includes: GOVT, IEF, ITE, PLW, TRSY
by: Matthew Salter, CFA

Summary

The Federal Reserve is forecasting an increase in rates to only 1% by December 2015 - two years from now we will still be a long way from "normalization."

After over five years of historically unprecedented low rates, the Fed has shifted back their forecasts on more than one occasion already.

Neither of the principal indicators of inflation or unemployment are close to long-term levels, making the continuation of ultra low rates a possibility for several more years.

A brief recap of recent Federal Reserve interest rates

On December 16th 2008, the Federal Reserve lowered the target Federal Funds reserve by 75 basis points, setting it at an unprecedented low new target of between zero and 25 bps (basis points).

Few at the time predicted that this unusual (and at the time, extraordinary) policy move would become a long lasting feature of US monetary policy. But, now over five years later, policy rates are still firmly anchored at these historical lows.

With glimpses of sustainable growth possibly emerging in the United States, the markets are looking for signals as to when rates may rise again to levels that are nearer historical "norms" - or "normalization" as it has been termed.

When does Fed itself think it will begin to raise interest rates?

A good place to start is with the Fed's own views as to when they themselves think rates will begin to rise. The minutes from earlier this month (March 2014) contained their latest projections. The most relevant points regarding interest rate normalization were that:

1. Most Federal Open Market Committee participants reiterated their view that the Fed will refrain from raising the benchmark interest rate until 2015, with two participants indicating no change would take place until 2016.

2. The notes to the Fed's minutes showed that officials predicted - the median prediction - that the target interest rate would be 1 percent at the end of 2015 and 2.25 percent a year later. (This was different from the December minutes, when they estimated the rate at the end of next year would be 0.75 percent and 1.75 percent for the end of 2016).

A few things are worth noting from this:

  • Though the Fed is predicting interest rates at the end of 2015 to be 1%, this is almost two years away and would still be a very long way from "normalization." In the current environment of almost zero percentage interest rates, it's sometime easy to forget that 1% is also an abnormally low level.
  • A lot of attention was paid to the fact that previous Fed forecasts were for interest rates to be 0.75% at the end of 2015 (instead of 1.0% in the latest minutes), so commentators read into this that the Fed were more bullish. In fact, the Fed forecasts in December 13 were lower than the previous forecasts for September 13, so the Fed adjusts according to latest data, and it would be too much to read into this a shift to a more bullish tone.
  • Though it's going back a while, it is worth remarking that in January 2012 the Fed were predicting normalization to begin this year (2014) with interest rates by the end of the year to be over 1%. The fact that this has been shifted back should be a good indicator that the Fed's projections are far from being concrete forecasts of actual outcomes.

Economic indicators the Federal Reserve is watching

The two main indicators the Federal Reserve decision makers are watching are:

  • Inflation
  • Labor Markets

These are crucial to influencing their predictions about when interest rates will first begin to rise, so a quick word on both is warranted.

Inflation

The Federal Reserve's favorite inflation measure is the price index of PCE (personal consumption expenditure), where they traditionally target a level of 2.0%. The graph below shows the recent historical trend for this index.

Apart from a brief time in March 2012, inflation has been below the Fed's target for more than five years. For the past year, inflation has been almost a full percentage point below the Fed's target. Indeed, recent inflation releases indicate that, if anything, the trend is still in a downward direction.

This is a matter of concern for the Fed, who remarked in their latest minutes that there was a growing uncertainty that inflation would move back towards the Committee's two percent objective over the medium term.

Labor markets

Almost six years after the onset of the recession, and unemployment has still not returned to "normal levels." The Fed recently referred to a level of 6.5% unemployment as being a threshold for interest rates to begin to rise. But this reference has been removed out of a realization that as the economy approaches this level, it is still not strong enough to withstand an increase in interest rates.

And even as the economy approaches this level, there are concerns about the tepid nature of the recovery in the labor markets this long into a so-called recovery, as well as the implications for the wider economy of a decline in participation rates to levels not seen for over 30 years.

One final point - policy moves are anticipated by markets and "priced in" a long time before they actually happen.

The graph below shows very nicely - and dramatically - how market yields do not react to the actual implementation of new monetary policy, but to the anticipation of that policy. Note how yields fell dramatically before QE1, QE2 and Operation Twist began, but moved upwards or sideways once they were implemented.

Similarly, note how yields rose before tapering began in anticipation, but have again moved sideways now it is finally being implemented.

So those who are concerned that the Federal Reserve hiking rates in 2015 will lead to a large increase in longer-term rates can probably relax knowing that, as with other policy moves by the Fed, the yield curve has already factored in any hikes in the next two years or so. In fact, if anything, the risks are to the downside and if the economy doesn't recover as smoothly as the Fed is currently expecting, then any delay in steps towards normalization could very quickly see long-term yields fall once more.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.