Federal Reserve Chairwoman Janet Yellen and other officials at the central bank are at odds with bond market investors as they meet this week in Washington to reach a decision about monetary policy.
Markets don’t believe Fed officials’ projections that they will raise interest rates twice this year and to nearly 2 percent by the end of next year.
Instead, futures prices on Monday indicated that investors see only one rate hike, at most, before the end of the year, and for short-term interest rates to remain below 1 percent throughout 2017.
In monetary policy terms, the difference is significant and one that the Fed may try to bridge in the statement it releases Wednesday. The divergence suggests that investors are expecting the Fed to keep monetary policy much looser than Yellen and others are thinking.
While the disconnect is not new, it is a new source of concern for Eric Rosengren, the head of the Federal Reserve Bank of Boston, who earlier this month raised the alarm that markets could be risking being caught off-guard.
“I do not see that the risks are so elevated, nor the outlook so pessimistic, as to justify the exceptionally shallow interest rate path” expected by investors, Rosengren said in a speech at Central Connecticut State University. Rosengren, who will be one of the voting members of the Fed’s monetary policy committee this week, said that if the Fed followed the course of rate increases investors expect, it would run the danger of “overheating” the economy; in other words, stoking high inflation.
Rosengren is not one for casually raising fears about inflation. In fact, he is generally viewed as one of the biggest “doves” within the Fed, meaning that he is generally more worried about unemployment being too high and less eager to raise rates to pre-empt rising inflation.
But he and the majority of the Fed have generally agreed that the central bank’s best course of action is to continue raising rates, if only gradually and cautiously, as the economy returns to health as they expect over the year.
Economists and investors suggested two major reasons why the private sector and the Fed are not on the same page.
One is simply that the market does not expect the economy grow as much as the Fed expects.
“People are just not convinced we’re out of the woods yet,” said Peter Hooper, chief economist at Deutsche Bank Securities.
Fed members projected in March that gross domestic product would grow 2.2 percent, adjusted for inflation, in 2016. Yet incoming economic data has fallen short of that pace: First-quarter growth will only be at a 0.3 percent annual rate, according to the Federal Reserve Bank of Atlanta.
A big part of the concern stems not from the U.S., where job growth has remained relatively strong, but from the possibility that Europe and Asia might falter economically, creating problems for U.S. businesses as well. Yellen and company have constantly told markets that bad economic news means fewer rate hikes.
The other major reason to doubt that the Fed will raise rates as fast as it says is that the central bank now has a track record of overestimating how quickly it will tighten monetary policy.
“The argument from the market would be: ‘Hey, the Fed continually lowers its projections for [interest rates], and especially in 2015 the Fed kept on talking about [raising] rates but only raised rates once,'” said John Silvia, chief economist for Wells Fargo. He noted that the Fed has only lowered, and never raised, its rate projections since December 2014, when members anticipated that short-term interest rates would be raised to about 2.5 percent by the end of 2016.
“There is a credibility issue attached to the forecasts,” Hooper said.
It’s a foregone conclusion among investors that Wednesday’s decision will not be a rate increase. The question is whether Yellen and company will choose to include some signal in the message that markets are on the right track or not.
One way to do that would be to eliminate or soften a current warning about risks from around the globe and in financial markets, or to replace it with a statement that the risks to the economy are “balanced,” a formulation the Fed has used in the past to communicate that it faces as much danger from waiting to raise rates as it does from raising them early.
Yet there are other reasons to believe they won’t do so. Yellen, for instance, suggested in her most recent speech in late March that financial markets were reacting appropriately to market data by more or lessing guessing how it would factor into the Fed’s decisionmaking. The markets, she said, were acting as an “automatic stabilizer,” effectively providing stimulus after bad economic news, such as the worrying signs from China and elsewhere overseas earlier this year.
Another is simply that Yellen, the ultimate decision-maker at the Fed, has found reasons to put off raising rates throughout her tenure.
“The Fed has had a tendency to kind of move the goalposts on us,” said Don Ellenberger, senior portfolio manager and head of multi-sector strategies for Federated Investors, an asset manager with more than $360 billion in assets under management. He cited that the Fed has previously set benchmarks for raising rates that it has subsequently changed or ignored, including the unemployment rate, financial markets or overseas growth, and recently the “equilibrium” short-term interest rate.
Underlying the Fed’s delay, Ellenberger said, is Yellen’s own reluctance to pursue tighter money. “Yellen’s a dove and I think people think she kind of has to talk tough on inflation but the reality is she doesn’t want to move and she’s not going to hike rates very quickly,” he said. “Until Yellen dissuades us of that notion, I think you’re going to continue to see discrepancy” between the Fed’s projections and the markets.
