Federal Reserve officials nudged their expected path of interest rate increases higher yesterday, but did little to change the outlook for a long slow climb back up to normal monetary policy.
The revised rate projections left a deep disconnect between the US central bank and financial markets, with investors anticipating significantly lower rates in the future than the Fed officials themselves project.
The so-called “dots” matrix from the Fed rate setters showed their median view of the appropriate federal funds rate by end-2015 at 1.375 per cent versus 1.125 per cent in their last projections in June. The end-2016 rate was pushed up to 2.875 per cent from 2.5 per cent. By the end of 2017, Fed officials see their target rate back at what they consider a neutral level of around 3.75 per cent.
Interest rate futures contract prices reflecting market views, by contrast, have been projecting rates of below 1 per cent for the end of 2015 and around 2 per cent at the end of 2016. That could set the stage for a disruptive readjustment if the market has to suddenly catch up.
In a news conference, Fed chair Janet Yellen noted that the central bank would likely be in an accommodative mode for years to come, but she also said officials would not hesitate to shift gears if conditions warrant.
“It is important for market participants to understand what our likely response or reaction function is to the data and communicate as clearly as we can the way in which our policy stance will depend on the data,” she said.
Some analysts said Yellen’s focus on uncertainty seemed calculated to move investors toward the Fed’s view.
“They want to remind the market that what it has been pricing in is too low. The increase in the dots in June is a pretty good indication that rates will be heading to more normal levels, certainly by end of 2017,” said Stephen Stanley, chief economist at Pierpoint Securities.
Once it decides to begin raising interest rates, likely in the middle of next year, the path the Fed follows from there has deep implications for markets and the economy.
Some officials are already concerned that years of low rates have laid the groundwork for a future financial shock, whether because of over-valued asset markets, another consumer credit bubble, or a shakeout in global markets once borrowing costs begin to rise. In this view, a slow crawl back to normal means years’ more monetary stimulus that could foster trouble.