FedWatch: Keep your eyes on the prize (i.e., long-run funds rate)


There’s broad consensus that the Fed will toe the line when the policy-setting Federal Open Market Committee (FOMC) meets next week, sticking with $10 billion in monthly tapering and maintaining an effective 0% target funds rate.  What most market observers will be homing in on is the magnitude of potential changes in the forecasts for unemployment and particularly the longer-term median funds rate.

On the former, we think the Fed could lower its unemployment rate projection in recognition of reaccelerating growth after the winter-related slowdown caused first-quarter GDP to contract. To the extent the unemployment rate falls faster than previously forecast, it could suggest a slightly more aggressive path for the hiking cycle, i.e., the move up in the target funds rate. That’s because faster progress will move the Fed more quickly toward its goal of full employment, considered to be around 5.5%.

That said, it will be interesting to see if the Fed lowers its long-run median estimate for the target funds rate. The neutral rate currently runs around 4% to 4.5%, assuming stable inflation at 2% and unemployment at 5.5%. But there has been speculation this long-run equilibrium funds rate could come down, primarily as slower population growth and lower productivity growth lower potential GDP growth. So to the extent the median long-run funds rate does come down, it could act to put a cap on any move up in longer rates even if the rate-hike cycle starts before current expectations for a late spring-early summer move in 2015.

This really would fit with new Fed Chair Janet Yellen’s desire to try and limit the market impact of when the Fed really starts to hike the funds rate. She wants to avoid another “Bernanke riot,’’ i.e., a sharp move up in long rates as occurred late last spring and early summer when the former Fed chairman put tapering on the table. The Fed’s concern about long rates is evidenced by its stated intention to continue to reinvesting proceeds from its mortgage securities holdings back into mortgages even after it initiates the rate-hike cycle.

Another wild card next week will be the addition of two new voting members to the FOMC, new Fed Vice Chairman Stanley Fischer and new Fed Governor Lael Brainard. We’ll let you know how it all shakes out next Wednesday after the meeting ends and we digest the new projections and Yellen’s post-meeting comments.