Attempting to predict future increases in the federal funds rate has proven to be a challenge for decision makers from both the public and private sides during this business cycle. A pattern of over-forecasting the fed funds rate has become apparent. Likewise, and somewhat unsurprisingly, this trend of over-shooting is also associated with predicting the future value of the 10-year Treasury, as its value is influenced by federal funds rate expectations. In this special report we present several possible contributing factors as to why this business cycle, in particular, has given forecasters so much trouble predicting the level of the fed funds rate.
Factor One: Stubbornly Low Inflation
Lower-than-expected inflation during this economic cycle has certainly loomed large in the minds of the FOMC members. Persistently below two-percent inflation is not consistent with the goals of the Federal Reserve’s dual mandate, one of which aims for price stability at two percent. The PCE deflator, the Fed’s preferred measure of price pressures in the economy, averaged 1.82 percent for 2010-14, and has averaged just 0.98 percent since early 2015. Despite its positive sign, inflation remains well below the Fed’s 2 percent target.
Where does inflation go from here? Recently, much of the discussion on Capitol Hill has surrounded the potential for an overhaul of the U.S. tax system, which would include tax cuts for both the corporate and personal side. A tax cut, if it in fact happens, may boost inflation in the short-term on the back on increased consumer/business spending during the late stages of the business cycle. However, this inflation implication is largely dependent on the nature of the tax cuts as well as the performance of the overall economy.
Factor Two: Muted GDP Growth
Average real GDP growth (YoY) remains relatively lackluster compared to past economic expansions, averaging only 1.7 percent between Q2 2009 and Q3 2017. This represents the smallest average gain in an economic cycle in the post-WW-II era. Again, given the current late cycle readings, along with rising labor costs and interest rates, as well as declining profits, it would be hard to imagine economic growth accelerating in the near future.
A complete discussion of the underlying components of GDP and the reasons for their relatively muted growth is beyond the scope of this report. It bears emphasizing, however, that the slow pace of GDP growth this cycle has restrained price pressures from building and thereby lowered the path of the fed funds rate relative to expectations.
Factor Three: Political Uncertainty
2016 was a volatile year for rate hike expectations as Brexit and the U.S. election caught markets and the FOMC off guard. For instance, before the Brexit vote in June of 2016, the fed funds Blue Chip Financial consensus in May looking to the end of 2016 was 0.90 percent; however, in the wake of the Brexit vote, the fed funds rate was estimated to be just 0.55 percent. In other words, the uncertainly caused by the Brexit vote rattled forecasters enough that the consensus estimate removed 1-2 rate hikes by the Federal Reserve for 2016. The subsequent U.S. presidential election swung the inflation expectation pendulum the other way, and thus the forecast for the Fed funds rates rose. Political elections and policy changes certainly have inflation implications, which feed into forecasters’ predictions on how the FOMC will react to potential price pressures.
Factor Four: Tapering the Balance Sheet
Another potential factor behind the slower pace of rate hikes is the historically large size of the Fed’s balance sheet. In hindsight, it is apparent that caution was required by the Fed as it sought to reduce its balance sheet while simultaneously hiking rates. With the plan to start shedding Treasuries and asset-backed securities in the midst of a tightening cycle, market participants feared disruptions to financial markets. However, in order to prepare markets, the Fed proceeded with caution. The slower pace of rate hikes was perhaps an indication that measures to reduce the balance sheet were on the horizon. Given the continued slow pace of economic growth and lack of inflation, it will be difficult for the FOMC to continue raising rates at their expected pace (as telegraphed via the ‘dot-plot’) while reducing the balance sheet. The Fed is more likely to reduce its balance sheet at its scheduled pace while raising rates at a more moderate pace.
The Outlook from Here
Most of these factors continue to occupy space in today’s economic environment. Thus, we largely expect the FOMC to proceed along their policy tightening path, albeit at a more cautious and restrained pace. A clear disconnect in predicting the fed funds rate exists between the market consensus, as measured by fed funds futures, and the Fed’s dot plot, which represents the FOMC members’ beliefs of where the fed funds rate should be at the end of a given year. While the market consensus has historically been a better gauge of the actual rate in the future, both forecasts tend to overshoot the actual fed funds figure. As of now, we expect the Fed to raise rates in December, and just two more times in 2018.
