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Keith Savard
Adjunct Fellow
Banking and Capital Flows and Capital Markets and Finance and Global Economy and Public Policy and Systemic Risk
Keith Savard is a fellow at the Milken Institute. He has extensive executive management experience with expertise in evaluating the interrelationship between economic fundamentals and activity in global financial and commodity markets. He also has a background in sovereign risk analysis and applying a disciplined economic approach to investment-portfolio decision-making.
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Prognosticators Busy After FOMC Meeting, but What Are They Missing?

By: Keith Savard
August 04, 2015
   
   

With the July meeting of the Federal Reserve’s interest-rate-setting committee behind us, prognosticators, analysts and pundits are ramping up their predictions. Most can be divided into two parts: When will the first increase in the federal funds rate take place, and at what pace will subsequent rate hikes ensue?

As to when the first increase will happen, the alchemy for deciding this generally consists of three ingredients combined in various ways. One is to look at market indicators such as inflation, employment, market interest rates, futures prices, and economic activity. At the moment, the U.S. five-year breakeven rate—an inflation gauge—is below 1.4 percent (with the five-year average at 1.83 percent). The latest monthly unemployment rate is 5.3 percent, the lowest level since April 2008. The U.S. yield curve has shown signs of flattening as interest rates at the front end have risen in anticipation of a near-term change in the federal funds rate. In contrast, the federal funds futures market suggests only a 40 percent chance that the Fed’s Federal Open Market Committee (FOMC) will raise rates in September. Real GDP growth picked up in the second quarter to 2.3 percent, but was lower than expected.

Janet Yellen7

In addition to market indicators, those in the business of predicting Fed moves also examine surveys to determine how their peers judge the situation. Currently, about 80 percent of economists polled believe that the FOMC will raise the federal funds rate by 25 basis points in September. One should not take this to the bank, as it were, as economists have often been known to be wrong.

Probably the most important element in helping to determine when the FOMC will act is the interpretation of the committee’s statement released at the end of each meeting. Over the years, this has become an intense exercise of parsing words and inferring nuance. The drafters of the FOMC statement have done their English instructors proud with their judicious choice of adjectives and adverbs and the strategic placement of commas. In the latest statement, Fed watchers focused on this sentence: “The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market….” The word some was singled out as indicating an additional hurdle that must be surmounted before the FOMC pulls the trigger. Many analysts, however, don’t expect this to be a factor before the September meeting because most high-frequency data point to continued improvement in the labor market.

Although prognosticators and others seem to have a reasonable grasp of what needs to be included for making a point estimate of the start of a monetary cycle, the same cannot be said for the pace of change during the cycle. Obviously the data dependency element becomes more problematic in that case as it relies largely on forecasts. The Federal Reserve’s own track record in this area has been quite poor, although other institutions such as the International Monetary Fund and international banks have not distinguished themselves either.

Much attention is now focused on the so-called dots, representing the likely future movement of policy interest rates as envisaged by members of the FOMC. The rate forecasts of individual members are not identified. Moreover, the economic assumptions that underlie each forecast are not revealed. Nevertheless, the exercise does provide a general mapping of the anticipated path of policy interest rates in the next few years.  

The coming reliance of policymakers on macroprudential policy is one crucial element that seems to have garnered little attention among those concerned with the course of monetary conditions. In the aftermath of the 2007-08 financial crisis and Great Recession, political leaders and policymakers have become highly sensitized to systemic risk—just look at some provisions on derivatives in the Dodd-Frank law. With macroprudential policy designated as the primary tool to fight systemic risk, it seems reasonable to assume that monetary officials will feel less compelled to raise policy interest rates when confronted with a potential hazard.

In such a situation, we might find it more likely that regulators would first elect to change the loan-to-value ratio in housing before considering raising the federal funds rate. Any number of similar possibilities could be envisaged, all with implications for asset performance that could diverge from outcomes under traditional rate-tightening scenarios. In these circumstances, investors would be best served to learn more about macroprudential policy and the potential impact it could have on returns. It seems like a good time for investors to begin a new playbook as the FOMC gets close to pulling the trigger on its first interest rate increase in almost a decade.  Subsequent hikes could be few and far between.