Tag: federal funds rate

Why Don’t Financial Markets Believe the Fed?

Fed Chair Jerome Powell holding a news conference following the March 22 meeting of the FOMC. Photo from Reuters via the Wall Street Journal.

On March 22, the Federal Open Market Committee (FOMC) unanimously voted to raise its target for the federal funds rate by 0.25 percentage point to a range of 4.75 percent to 5.00 percent.  The members of the FOMC also made economic projections of the values of certain key economic variables. (We show a table summarizing these projections at the end of this post.) The summary of economic projections includes the following “dot plot” showing each member of the committee’s forecast of the value of the federal funds rate at the end of each of the following years. Each dot represents one member of the committee.

If you focus on the dots above “2023” on the vertical axis, you can see that 17 of the 18 members of the FOMC expect that the federal funds rate will end the year above 5 percent.

In a press conference after the committee meeting, a reporter asked Fed Chair Jerome Powell was asked this question: “Following today’s decision, the [financial] markets have now priced in one more increase in May and then every meeting the rest of this year, they’re pricing in rate cuts.” Powell responded, in part, by saying: “So we published an SEP [Summary of Economic Projections] today, as you will have seen, it shows that basically participants expect relatively slow growth, a gradual rebalancing of supply and demand, and labor market, with inflation moving down gradually. In that most likely case, if that happens, participants don’t see rate cuts this year. They just don’t.” (Emphasis added. The whole transcript of Powell’s press conference can be found here.)

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk–such as a sudden increase in oil prices or in interest rates–and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banks, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart shows values after trading of federal funds futures on March 24, 2023.

The chart shows six possible ranges for the federal funds rate after the FOMC’s last meeting in December 2023. Note that the ranges are given in basis points (bps). Each basis point is one hundredth of a percentage point. So, for instance, the range of 375-400 equals a range of 3.75 percent to 4.00 percent. The numbers at the top of the blue rectangles represent the probability that investors place on that range occurring after the FOMC’s December meeting. So, for instance, the probability of the federal funds rate target being 4.00 percent to 4.25 percent is 28.7 percent. The sum of the probabilities equals 1.

Note that the highest target range given on the chart is 4.50 percent to 4.75 percent. In other words, investors in financial markets are assigning a probability of zero to an outcome that the dot plot shows 17 of 18 FOMC members believe will occur: A federal funds rate greater than 5 percent. This is a striking discrepancy between what the FOMC is announcing it will do and what financial markets think the FOMC will actually do.

In other words, financial markets are indicating that actual Fed policy for the remainder of 2023 will be different from the policy that the Fed is indicating it intends to carry out. Why don’t financial markets believe the Fed? It’s impossible to say with certainty but here are two possibilities:

  1. Markets may believe that the Fed is underestimating the likelihood of an economic recession later this year. If an economic recession occurs, markets assume that the FOMC will have to pivot from increasing its target for the federal funds rate to cutting its target. Markets may be expecting that the banks will cut back more on the credit they offer households and firms as the banks prepare to deal with the possibility that substantial deposit outflows will occur. The resulting credit crunch would likely be enough to push the economy into a recession.
  2. Markets may believe that members of the FOMC are reluctant to publicly indicate that they are prepared to cut rates later this year. The reluctance may come from a fear that if households, investors, and firms believe that the FOMC will soon cut rates, despite continuing high inflation rates, they may cease to believe that the Fed intends to eventually bring the inflation back to its 2 percent target. In Fed jargon, expectations of inflation would cease to be “anchored” at 2 percent. Once expectations become unanchored, higher inflation rates may become embedded in the economy, making the Fed’s job of bringing inflation back to the 2 percent target much harder.

In late December, we can look back and determine whose forecast of the federal funds rate was more accurate–the market’s or the FOMC’s.

The FOMC Splits the Difference with a 0.25 Percentage Point Rate Increase

Photo from the Wall Street Journal.

At the conclusion of its meeting today (March 22, 2023), the Federal Reserve’s Federal Open Market Committee (FOMC) announced that it was raising its target for the federal funds rate from a range of 4.50 percent to 4.75 percent to a range of 4.75 percent to 5.00 percent. As we discussed in this recent blog post, the FOMC was faced with a dilemma. Because the inflation rate had remained stubbornly high at the beginning of this year and consumer spending and employment had been strongly increasing, until a couple of weeks ago, financial markets and many economists had been expecting a 0.50 percentage point (or 50 basis point) increase in the federal funds rate target at this meeting. As the FOMC noted in the statement released at the end of the meeting: “Job gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low. Inflation remains elevated.”

But increases in the federal funds rate lead to increases in other interest rates, including the interest rates on the Treasury securities and mortgage-backed securities that most banks own. On Friday, March 10, the Federal Deposit Insurance Corporation (FDIC) was forced to close the Silicon Valley Bank (SVB) because the bank had experienced a deposit run that it was unable to meet. The run on SVB was triggered in part by the bank taking a loss on the Treasury securities it sold to raise the funds needed to cover earlier deposit withdrawals. The FDIC also closed New York-based Signature Bank. San Francisco-based First Republic Bank experienced substantial deposit withdrawals, as we discussed in this blog post. In Europe, the Swiss bank Credit Suisse was only saved from failure when Swiss bank regulators arranged for it to be purchased by UBS, another Swiss bank. These problems in the banking system led some economists to urge that the FOMC keep its target for the federal funds rate unchanged at today’s meeting.

Instead, the FOMC took an intermediate course by raising its target for the federal funds rate by 0.25 percentage point rather than by 0.50 percentage point. In a press conference following the announcement, Fed Chair Jerome Powell reinforced the observation from the FOMC statement that: “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” As banks, particularly medium and small banks, have lost deposits, they’ve reduced their lending. This reduced lending can be a particular problem for small-to medium-sized businesses that depend heavily on bank loans to meet their credit needs. Powell noted that the effect of this decline in bank lending on the economy is the equivalent of an increase in the federal funds rate.

The FOMC also released its Summary of Economic Projections (SEP). As Table 1 shows, committee members’ median forecast for the federal funds rate at the end of 2023 is 5.1 percent, indicating that the members do not anticipate more than a single additional 0.25 percentage point increase in the target for the federal funds rate. The members expect a significant increase in the unemployment rate from the current 3.6 percent to 4.5 percent at the end of 2023 as increases in interest rates slow down the growth of aggregate demand. They expect the unemployment rate to remain in that range through the end of 2025 before declining to the long-run rate of 4.0 percent in later years. The members expect the inflation rate as measured by the personal consumption (PCE) price index to decline from 5.4 percent in January to 3.3 percent in December. They expect the inflation rate to be back close to their 2 percent target by the end of 2025.

The Fed’s Latest Dilemma: The Link between Monetary Policy and Financial Stability

AP photo from the Wall Street Journal

Congress has given the Federal Reserve a dual mandate of high employment and price stability. In addition, though, as we discuss in Macroeconomics, Chapter 15, Section 15.1 (Economics, Chapter 25, Section 25.1) and at greater length in Money, Banking, and the Financial System, Chapter 15, Section 15.1, the Fed has other goals, including the stability of financial markets and institutions. 

Since March 2022, the Fed has been rapidly increasing its target for the federal funds rate in order to slow the growth in aggregate demand and bring down the inflation rate, which has been well above the Fed’s target of 2 percent. (We discuss monetary policy in a number of earlier blog posts, including here and here, and in podcasts, the most recent of which (from February) can be found here.) The target federal funds rate has increased from a range of 0 percent to 0.25 percent in March 2022 to a range of 4.5 percent to 4.75 percent. The following figure shows the upper range of the target for the federal funds rate from January 2015 through March 14, 2023.

This morning (Tuesday, March 14, 2023), the Bureau of Labor Statistics (BLS) released its data on the consumer price index for February. The following figure show inflation as measured by the percentage change in the CPI from the same month in the previous year (which is the inflation measurement we use most places in the text) and as the percentage change in core CPI, which excludes prices of food and energy. (The inflation rate computed by the percentage change in the CPI is sometimes referred to as headline inflation.) The figure shows that although inflation has slowed somewhat it is still well above the Fed’s 2 percent target. (Note that, formally, the Fed assesses whether it has achieved its inflation target using changes in the personal consumption expenditures (PCE) price index rather than using changes in the CPI. We discuss issues in measuring inflation in several blog posts, including here and here.)

One drawback to using the percentage change in the CPI from the same month in the previous year is that it reduces the weight of the most recent observations. In the figure below, we show the inflation rate measured by the compounded annual rate of change, which is the value we would get for the inflation rate if that month’s percentage change continued for the following 12 months. Calculated this way, we get a somewhat different picture of inflation. Although headline inflation declines from January to February, core inflation is actually increasing each month from November 2022 when, it equaled 3.8 percent, through February 2023, when it equaled 5.6 percent. Core inflation is generally seen as a better indicator of future inflation than is headline inflation.

The February CPI data are consistent with recent data on PCE inflation, employment growth, and growth in consumer spending in that they show that the Fed’s increases in the target for the federal funds rate haven’t yet caused a slowing of the growth in aggregate demand sufficient to bring the inflation back to the Fed’s target of 2 percent. Until last week, many economists and Wall Street analysts had been expecting that at the next meeting of the Fed’s Federal Open Market Committee (FOMC) on March 21 and 22, the FOMC would raise its target for the federal funds rate by 0.5 percentage points to a range of 5.0 percent to 5.25 percent.

Then on Friday, the Federal Deposit Insurance Corporation (FDIC) was forced to close the Silicon Valley Bank (SVB). As the headline on a column in the Wall Street Journal put it “Fed’s Tightening Plans Collide With SVB Fallout.” That is, the Fed’s focus on price stability would lead it to continue its increases in the target for the federal funds rate. But, as we discuss in this post from Sunday, increases in the federal funds rate lead to increases in other interest rates, including the interests rates on the Treasury securities, mortgage-backed securities, and other securities that most banks own. As interest rates rise, the prices of long-term securities decline. The run on SVB was triggered in part by the bank taking a loss on the Treasury securities it sold to raise the funds needed to cover deposit withdrawals.

Further increases in the target for the federal funds rate could lead to further declines in the prices of long-term securities that banks own, which might make it difficult for banks to meet deposit withdrawals without taking losses on the securities–losses that have the potential to make the banks insolvent, which would cause the FDIC to seize them as it did SVB. The FOMC’s dilemma is whether to keep the target for the federal funds rate unchanged at its next meeting on March 21 and 22, thereby keeping banks from suffering further losses on their bond holdings, or to continue raising the target in pursuit of its mandate to restore price stability.

Some economists were urging the FOMC to pause its increases in the target federal funds rate, others suggested that the FOMC increase the target by only 0.25 percent points rather than by 0.50 percentage points, while others argued that the FOMC should implement a 0.50 increase in order to make further progress toward its mandate of price stability.

Forecasting monetary policy is a risky business, but as of Tuesday afternoon, the likeliest outcome was that the FOMC would opt for a 0.25 percentage point increase. Although on Monday the prices of the stocks of many regional banks had fallen, during Tuesday the prices had rebounded as investors appeared to be concluding that those banks were not likely to experience runs like the one that led to SVB’s closure. Most of these regional banks have many more retail deposits–deposits made be households and small local businesses–than did SVB. Retail depositors are less likely to withdraw funds if they become worried about the solvency of a bank because the depositors have much less than $250,000 in their accounts, which is the maximum covered by the FDIC’s deposit insurance. In addition, on Sunday, the Fed established the Bank Term Funding Program (BTFP), which allows banks to borrow against the holdings of Treasury and mortgage-back securities. The program allows banks to meet deposit withdrawals by borrowing against these securities rather than by having to sell them–as SVB did–and experience losses.

On March 22, we’ll find out how the Fed reacts to the latest dilemma facing monetary policy.

Podcasts Back for Fall 2022! – 9/9/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, cryptocurrency, and also briefly touch on labor markets.

4/07/22 Podcast – Authors Glenn Hubbard & Tony O’Brien revisit the role of inflation in today’s economy & likely Fed responses in trying to manage it.

Authors Glenn Hubbard and Tony O’Brien reconsider the role of inflation in today’s economy. They discuss the Fed’s possible responses by considering responses to similar inflation threats in previous generations – notably the Fed’s response led by Paul Volcker that directly led to the early 1980’s recession. The markets are reflecting stark differences in our collective expectations about what will happen next. Listen to find out more about the Fed’s likely next steps.

New Information on Fed Policy Affects Stock and Bond Prices

Jerome Powell (photo from the Wall Street Journal)

Most economists believe that monetary policy actions, such as changes in the Fed’s pace of buying bonds or in its target for the federal funds rate, affect real GDP and employment only with a lag of several months or longer. But monetary policy actions can have a more immediate effect on the prices of financial assets like stocks and bonds. 

Investors in financial markets are forward looking because the prices of financial assets are determined by investors’ expectations of the future. (We discuss this point in Economics and Microeconomics, Chapter 8, Section 8.2, Macroeconomics, Chapter 6, Section 6.2, and Money, Banking and the Financial System, Chapter 6.) For instance, stock prices depend on the future profitability of firms, so if investors come to believe that future economic growth is likely to be slower, thereby reducing firms’ profits, the investors will sell stocks causing stock prices to decline.

Similarly, holders of existing bonds will suffer losses if the interest rates on newly issued bonds are higher than the interest rates on existing bonds. Therefore, if investors come to believe that future interest rates are likely to be higher than they had previously expected them to be, they will sell bonds, thereby causing their prices to decline and the interest rates on them to rise. (Recall that the prices of bonds and the interest rates (or yields) on them move in opposite directions: If the price of a bond falls, the interest rate on the bond will increase; if the price of a bond rises, the interest rate on the bond will decrease. To review this concept, see the Appendix to Economics and Microeconomics Chapter 8, the Appendix to Macroeconomics Chapter 6, and Money, Banking, and the Financial System, Chapter 3.)

Because monetary policy actions can affect future interest rates and future levels of real GDP, investors are alert for any new information that would throw light on the Fed’s intentions. When new information appears, the result can be a rapid change in the prices of financial assets. We saw this outcome on January 5, 2022, when the Fed released the minutes of the Federal Open Market Committee meeting held on December 14 and 15, 2021. At the conclusion of the meeting, the FOMC announced that it would be reducing its purchases of long-term Treasury bonds and mortgage-backed securities.  These purchases are intended to aid the expansion of real GDP and employment by keeping long-term interest rates from rising. The FOMC also announced that it intended to increase its target for the federal funds rate when “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”

When the minutes of this FOMC meeting were released at 2 pm on January 5, 2022, many investors realized that the Fed might increase its target for the federal funds rate in March 2022—earlier than most had expected. In this sense, the release of the FOMC minutes represented new information about future Fed policy and the markets quickly reacted. Selling of stocks caused the S&P 500 to decline by nearly 100 points (or about 2 percent) and the Nasdaq to decline by more than 500 points (or more than 3 percent). Similarly, the price of Treasury securities fell and, therefore, their interest rates rose. 

Investors had concluded from the FOMC minutes that economic growth was likely to be slower during 2022 and interest rates were likely to be higher than they had previously expected. This change in investors’ expectations was quickly reflected in falling prices of stocks and bonds.

Sources: An Associated Press article on the reaction to the release of the FOMC minutes can be found HERE; the FOMC’s statement following its December 2021 meeting can be found HERE; and the minutes of the FOMC meeting can be found HERE.