In June, the FOMC declined to begin the long process of normalizing interest rates. However, the Committee still positioned itself to raise rates later this year for the first time in nearly a decade. Investors are increasingly focused on what the Fed’s new rate regime will look like and FOMC words and actions have given us some insight into this. Here are answers to four key questions about the FOMC and future interest rates:
What does the FOMC need to see before normalizing interest rates?
Federal Reserve chair Janet Yellen stated after June’s FOMC meeting that policy makers wished to see “more evidence that a moderate pace of economic growth will be sustained”.
This means two things:
1. The labor market needs to continue creating jobs and reducing slack. Job gains of more than 200,000, labor force participation rates trending upward and further signs of nascent wage growth are key indicators.
2. With regard to inflation, the FOMC has to be “reasonably confident” that it will return to the Fed’s 2 percent. This does not mean that inflation has to actually be within the Fed’s target range — just clearly headed in that direction.
What will the pace of rate normalization be like?
During the previous tightening cycle from 2004 - 2005, the FOMC mechanically raised rates by a quarter of a percent at each meeting. Fed Chair Janet Yellen has hammered away at the misguided premise that the coming tightening cycle will resemble the previous one. For example, at her press conference following the June meeting, Chair Yellen once again stressed that this cycle will be “slow” and “gradual” and may include pauses along the way.
Fed vice chair Stanley Fischer has also spoken about the expected slow pace of normalization. In fact, he seemingly went out of his way to emphasize this point:
“You say ‘liftoff’ and you think of rockets that go into orbit after ten seconds. That’s not what we are talking about.”
“ ‘Liftoff’ says we’re going straight up with the interest rate. Well, we’re going up with the interest rate, then along, and then another little jump. That’s not liftoff; that’s crawling.”
At what level will interest rate peak in this tightening cycle?
Minutes of recent FOMC meetings reveal that the group has spent considerable time deliberating the neutral rate of policy. The accounts of these discussions portray a general consensus around the peak rates in the future being lower than in the past. Fed forecasts have been consistent with this as well. The historical average for long-run policy is around 4.25 percent. June’s revised forecasts by FOMC members had the consensus peak policy rate around 3.50 percent, however.
When will the FOMC embark on its new “slow and low” regime?
The FOMC will begin their new regime in December 2015. I expect the economic data to continue to improve and provide an opening for a rate move in December. This initial increase will be followed by a pause for a meeting or two in 2016 to allow markets to fully digest the change in regime.
What is the rationale behind this call? The Fed has two prominent biases:
· The FOMC has been clear about their bias to initiate normalization in 2015. Despite a very disappointing first quarter, this bias remains intact. At June’s meeting, 15 of 17 participants still expected an increase this year
· The FOMC also has a bias to launch the new regime on the back of strong economic data. I expect the economy will continue to add more than 200,000 jobs monthly. More important, there are growing signs of diminishing slack: The participation rate is beginning to trend upward, and multiple measures of wage growth are moving higher as well.
As for inflation, some measures of inflation have already moved toward the Fed’s 2 percent objective, but the Fed’s favored measure, core personal consumption expenditures (PCE), has lagged those. I expect core PCE to stabilize over the summer and turn upward sometime in the fall.
While a rate hike will be on the table in September, I do not think the FOMC will pull the trigger just yet. Coming off the longest stretch of sub-2 percent inflation in nearly 50 years, we expect the FOMC to be doubly sure that any upward trend in inflation is both sustained and strong before moving forward. Additionally, global market turbulence over the summer from the slowly unfolding Greek drama, may give the Fed reason to see how it all plays out before raising rates in July or September