17 Mar 2015
Divergence in market expectations for Fed rates - SocGen
FXStreet (Bali) - As Societe Generale notes, market expectations for future policy rates are distinctly different from those projected by the FOMC.
Key Quotes
"In deciding the most optimal rate path, the FOMC has to consider not just the economic outlook, but also the impact of its actions on financial conditions and the risks associated with using an unproven exit toolkit. Market expectations for future policy rates are distinctly different from those projected by the FOMC."
"The gap, measured relative to the median FOMC forecast, currently equals 60 basis points as of year-end 2015; 110 basis points as of year end 2016; and nearly 140 basis points as of year-end 2017. Since the Fed defines its forecast as the “appropriate path of policy firming”, arguably it wants market expectations to converge to the “dots”, provided that the FOMC’s underlying economic forecasts come to fruition."
"However, this would almost certainly produce a significant shock to financial conditions. Spreading out the first two rate increases and picking up speed in 2016 should promote a more gradual repricing of market expectations."
"Allowing a longer pause between the first and second rate hikes would also give the Fed ample time to test its new exit toolkit under non-zero rate conditions. While the new facilities – including the overnight reverse repo (ON RRP) – have been extensively tested over the pasttwo years, they may perform very differently once rates are lifted away from the zero lower bound. In the January FOMC minutes, participants noted that it is critical that the beginning of normalization is successful, i.e. that the effective fed funds rate trades inside of the new (0.25-0.5%) target range. They will not proceed with the second increase until they are fully in control of overnight market rates."
"The FOMC’s median forecast for the fed funds rate currently (as of December) calls for four rate increases this year. Given our scenario, we believe that this will be revised down, most likely in a gradual fashion. This is easy to justify as the Fed’s near-term inflation forecast is also likely to come down. By dropping the reference to “patience” and beginning an orderly retreat on the “dots”, the Fed should be able to limit the market reaction and keep financial conditions broadly unchanged."
Key Quotes
"In deciding the most optimal rate path, the FOMC has to consider not just the economic outlook, but also the impact of its actions on financial conditions and the risks associated with using an unproven exit toolkit. Market expectations for future policy rates are distinctly different from those projected by the FOMC."
"The gap, measured relative to the median FOMC forecast, currently equals 60 basis points as of year-end 2015; 110 basis points as of year end 2016; and nearly 140 basis points as of year-end 2017. Since the Fed defines its forecast as the “appropriate path of policy firming”, arguably it wants market expectations to converge to the “dots”, provided that the FOMC’s underlying economic forecasts come to fruition."
"However, this would almost certainly produce a significant shock to financial conditions. Spreading out the first two rate increases and picking up speed in 2016 should promote a more gradual repricing of market expectations."
"Allowing a longer pause between the first and second rate hikes would also give the Fed ample time to test its new exit toolkit under non-zero rate conditions. While the new facilities – including the overnight reverse repo (ON RRP) – have been extensively tested over the pasttwo years, they may perform very differently once rates are lifted away from the zero lower bound. In the January FOMC minutes, participants noted that it is critical that the beginning of normalization is successful, i.e. that the effective fed funds rate trades inside of the new (0.25-0.5%) target range. They will not proceed with the second increase until they are fully in control of overnight market rates."
"The FOMC’s median forecast for the fed funds rate currently (as of December) calls for four rate increases this year. Given our scenario, we believe that this will be revised down, most likely in a gradual fashion. This is easy to justify as the Fed’s near-term inflation forecast is also likely to come down. By dropping the reference to “patience” and beginning an orderly retreat on the “dots”, the Fed should be able to limit the market reaction and keep financial conditions broadly unchanged."