Federal Reserve officials are starting to shift their forward policy guidance from the tapering of quantitative easing to the eventual exit from the zero-bound interest rates, even though such a move is probably more than a year away.
The updated forward guidance goes beyond the timing of the first rate hike and focuses on the possible peak in short-term interest rates to be reached in the prospective tightening cycle. That tightening cycle is likely to span several years as the Fed only very gradually raises interest rates.
New York Fed president William Dudley gave three reasons last month that he believes the equilibrium nominal short-term rate is lower than the historical 4.25 percent.
First, economic headwinds in the form of greater precautionary savings and less investment by businesses and households are likely to persist for several more years.
Second, the aging of the population will lead to slower growth in the labor force and moderate productivity growth implies a lower potential real GDP growth rate.
Third, tighter bank regulation and higher capital requirements will lower equilibrium short-term rates somewhat.
Dudley’s comments were followed a day later by the release of the minutes of the Federal Reserve’s April 29-30 Federal Open Market Committee meeting. Overall, the sentiment was very dovish and hinted that other Fed officials share Dudley’s outlook for a lower-than-normal equilibrium short-term rate.
A number of Fed officials remain concerned about the persistent low level of inflation and expect it to take a few years before it returns to the 2 percent target. As such, these Fed officials would expect very slow climb towards the peak, and potentially a lower peak.
We believe the markets are likely to see more formal forward guidance from the Federal Reserve, suggesting that the equilibrium nominal rate is in the 3 percent range, below the traditional 4 percent level.
Such guidance would essentially validate present bond prices and yields, because since the start of the year bond market participants have downgraded their expectations for Fed tightening. Looking at the Eurodollar futures curve, we estimate that the market is not pricing in a 3 percent Fed target rate until 2019.
But, the question for the markets is whether such a dovish interest rate scenario unfolds. While many key Fed officials are concerned about the downside risks to the US economy and below-target inflation, some reported signs of tight labor markets in their districts, and some sectors or occupations were experiencing worker shortages.
This could indicate less slack in the labor market and argue for a faster increase in short-term rates and a possible higher terminal level. We see heightened risks that the Fed will make a policy mistake.
The writer is director of US macro investors services at Oxford Economics.
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