Group Economics
US Watch
Macro & Financial Markets Research Maritza Cabezas, +31 20 343 5618
Fed preparing for lift-off
13 August 2015 We expect the Fed to raise interest rates in September. GDP is growing above trend and we are seeing further improvement in the employment situation. In our view, the Fed will maintain a 25bp target range for the Fed funds rate, which implies that the first move will shift the target range to 25-50bp, ending at 50bp-75bp at the end of 2015 and 150bp-175bp at the end of 2016. All together this means one rate hike every other meeting in 2015 and 2016. The slow pace of rate hikes takes into consideration the somewhat tighter financial conditions, resulting from the strong dollar, given that the Fed is far ahead of other central banks. In line with this view our EUR/USD forecast for the end of 2015 remains 1.00. Introduction
Past and Present Tightening cycles in US economy %
Fed policymakers are giving signals that they are getting ready to hike rates this year. The US economy looks strong enough
8
to handle a rate hike. In this note we address how the Fed is
5.7
preparing for the rate hike, the path for interest rate normalisation and the instruments that the Fed could use in
5.4
4.2 4 2.3
2.2 1.3
this process. 0
Economy ready for a rate hike
GDP growth
unemployment
core PCE
This time around, the economy may not be as resilient but the 1 yr before
fundamental factors underlying US economic activity are solid
Now
and, in time, should lead to a pick-up in the pace of economic activity and inflation. Recently Fed policymakers have
Source: Thomson Reuters Datastream
mentioned that the economy would need to show “some” improvement before a rate hike. Since then statements from
Labour market conditions firm, wages subdued
Fed officials suggest that the economy is moving in the right
Unemployment has declined significantly during the recovery.
direction. For instance, Dennis Lockhart, President of the
Moreover, job openings and quits have been steadily
Federal Reserve Bank of Atlanta said in an interview with the
improving in the past year. However, wage growth remains
Wall Street Journal that a Fed rate hike is ‘close’, noting that
subdued. We think that slower productivity growth could be
he is open for a September move. Meanwhile, the President of
keeping wages supressed, since higher wages in a context of
the Fed St. Louis, James Bullard (voting in 2016) told the WSJ
lower productivity reduce profit margins. However, this should
late in July that “we are in good shape” for a rate hike in
not be an impediment to a rate hike. Fed Chair Yellen has
September. In this same line, President John Williams of the
repeatedly stated that higher wage growth is not a necessary
Federal Reserve Bank of San Francisco also reiterated his
condition for a rate hike.
forecast for a rate liftoff this year. In time, inflation should move towards the target GDP growth, lower but above trend
Inflation may look distant from the Fed’s 2% goal, but this is a
Long trend GDP growth has slipped somewhat since the global
medium-term objective. We expect that inflation will remain
financial crisis. Indeed, average trend growth was around
below 1% this year, but will move towards the 2% target next
3.1%, but the global financial crisis took its toll with a loss in
year. The strong economy should see slack dissipate, which
output and potential growth now around 2%. This suggests
should push up inflation. In addition, rising rent prices and the
that although US economic growth is lower than in previous
reduced pass-through from the stronger dollar should also lead
cycles, it is currently growing at above-trend rates. As a result,
to price increases in the coming months. Fed officials have
slack is diminishing and this is likely one of the major reasons
persistently signalled that they expect some of the factors that
the Fed will hike .
are exerting pressure on prices to wane.
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Fed preparin ng for lift-off – 13 1 August 2015 5
The e Fed’s path ffor monetary tightening t
Interest on exce ess reserves aand policy ratte
In September S 201 14, the FOMC published “Policy Normalisat ion
It is likely that the e Fed will use tthe Interest on n Excess Reserrves
Prin nciples and Pla ans”. This docu ument provides s a broad outlin ne
(IO OER) to influen nce the federal funds rate. Ind deed, we think
of how h the FOMC C intends to norrmalise moneta ary policy
that this deposit rate will be thee most importa ant instrument to
following almost tten years of extreme accomm modation, which h
aise key rates. This T rate will ccorrespond to the t upper limit of ra
included unconve entional moneta ary policy instru uments. The
the target range..
Prin nciples indicate e that the Fed will w continue to o use a 25bp Unconventiona U al policies pusshed up reserrves
targ get range for th he federal fund ds rate.
B Bn Plo otting the Fed’’s exit
5000
Fed d officials publiish their own outlook for the feds f fund rate, the e so called “dot plot”. The Fed d has forecaste ed that in 2015,, the e midpoint of the target range will be 62.5bp, increasing to nd 162 2.5bp in 2016. This is in line with w a target ra ange of 0.5% an 0.7 75% and 1.5% - 1.75%, respe ectively. These forecasts have e bee en adjusted downward in the past few FOMC meetings in
4000 3000 2000 1000 0 04
line e with downwarrd adjustmentss in GDP and in nflation.
0 06
07
Balancce sheet Fed
09 9
10
12
13
15
Deposits/reserves at the Fed
Fe ed has becom me more cauttious on rate hikes %
So ource: Thomso on Reuters Dattastream
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3.5
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2.5
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sin nce 2009. Gov vernment Spon sored Entities, including the mortgage financial entities, aree not allowed to o deposit at the e ed and have be een willing to leend their exces ss funds at a lo ower Fe ra ate than the IOE ER. As banks bbenefit from thiis arbitrage by bo orrowing from the GSE and d epositing in the e Fed, they are e lik kely to compete e for the funds of agencies un ntil the effective e ra ate has risen clo ose to the depoosit rate. he Fed already y seems to be ppreparing for th he use of this to ool. Th
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Th his past June, the t Fed annou nced that the IOER payments
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wiill be based on the daily IEOR R rate, rather th han the averag ge
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ra ate over a full tw wo-week reservve maintenanc ce period. We
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think the intentio on is to increasee the effectiven ness of change es
1.5
m the fedeeral funds rate. On top of this,, the in the IEOR in moving
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ed will likely use other tools likke the RRP an nd the TDF to Fe
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he IOER has been significanttly above the fe ederal funds ra ate Th
drrain reserves more m quickly. Thhe draining of reserves will le ead
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to a convergence e of the federaal funds rate an nd the IOER. ●●●● ●● 0.5
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●● 0 2015 5
Sou urce: Federal R Reserve
201 16
2017 7
Longer run n
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Fed preparin ng for lift-off – 13 1 August 2015 5
Fe ed’s deposit rrate leading in setting policy rate
Financial F cond ditions tighteening
%
% % 8 6
0.25
4
tightening
2
forecasts
0 -2 -4 -6
0 10
11
12
13
14
1
91
93
9 95
98
00
03
FCI
US fed fundss rate
IOER R
05
07
10
12
15
GDP growth
Do otted lines indicate es rate hike lift-offf So ource: Thomson Reuters R Datastream m, ABN AMRO Group Economics
Sou urce: Thomson Re euters Datastream m
wards Fed’s forecast Investors slowly moving tow We e expect snail--paced rate hikes
Att the forefront of o this rate tighttening cycle, in nvestors have
The e effectivenesss of monetary policy p largely depends on the e pre evailing financia al conditions du uring and after the lift-off. Fin nancial conditio ons are determined by movem ments in marke et varriables that are important for growth g and inflation, including g ma arket rates, cred dit spreads, eq quity prices and d the exchange e rate e. Given the tig ghter financial conditions, c the Fed is signalli ng a more m gradual pa ace of rate hike es than we are e accustomed tto. Indeed, the avera age rate hike in n past cycles was 355bp and this s time the FOM MC has forecassted around 300 0bp, suggestin ng
be een sceptical about the Fed hhiking rates in the t short term, mainly given the uncertainty arround the globa al economy. Att the sa ame time, Fed officials have bbecome a bit more m cautious in n their forecasts in n the past few m meetings. How wever, the gradual mprovement in economic e dataa has led investtors to shift the eir im ex xpectations to a December raate hike. But th his move has further to go. A hike h in the Fed''s target range is fully priced in for December, but only a few aare placed in September ac ccording to futu ures markets.
tha at the Fed will liikely opt for a more m gradual pace. p
Markets M slowly moving tow wards a rate hike h this yearr Pa ace of US rate e hike cycle different d this time Tim me since last ratte
Startt of rate hike
hike e
cycle e
% %
Average inccrease 0.7 0.6
1 ye ear
3/29/1988
375bp
5 ye ears
2/3/1994
300bp
5 ye ears
6/30/1999
175bp
5 ye ears
6/30/2004
425bp
0.3
10 years y
2015 ?
300bp ?
0.2
Sou urce: ABN AMRO Group Economicss
0.5 0.4
0.1 0 2-Jan
eb 2-Mar 2-Fe
2-Ap pr 2-May 2-Jun n
2-Jul
2-Aug g
We e see that finan ncial conditionss have been tightening since mid d-2014. We thin nk that financia al conditions co ould tighten a b bit mo ore with the Fed d leading the ra ate hike cycle. The ECB and
So ource: Bloomberg
the e BoJ are still in n an easing mo ode. This will re esult in an even n stro onger dollar.
Our interest rate forecasts We W see an economy that is groowing above tre end. While the labour market re emains solid. W We expect “som me” further mprovement ahead as the gainns in the job market m continue e to im su upport the econ nomy. This is w what the Fed wants w to see before a rate hike. Cons sequently, a raate hike in Septtember remains ur view. Tighterr financial condditions will, how wever, lead the e ou Fe ed to opt for a significantly s sloower pace of ra ate hikes than we w
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Fed preparin ng for lift-off – 13 1 August 2015 5
had d initially expeccted. We mainttain our view th hat the federal funds rate will rise e to 0.5% - 0.75% at year-end d 2015. This iss in line e with the Fed’ss midpoint targ get and implies two rate hikess this s year, one in S September and d December. Fo or 2016, we ha ave low wered our policyy rate forecast range to 1.5% % - 1.75% from 2% % - 2.25%. This adjustment co oincides with th he Fed’s midpo oint fore ecast for 2016 and implies a rate hike every y other meeting g nex xt year. In line w with this view our o EUR/USD forecast for the e end d of 2015 is 1.0 00.
Ga ap between m markets and Fed F rate forec casts %
1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0
1.625
1.625
1.055 0.62 25
0.625
0.35
Fed
kets Mark 2015
ABN AMRO
2016
Sou urce: Bloomberg, A ABN AMRO
sks to our fore ecasts Ris Nonetheless, the ere are downsside risks to our interest ra ate ecasts, particularly surrounding internationa al developmentts . fore Negotiations bettween Greece e and its crreditors are sstill unc certain. Chinesse GDP grow wth looks to have h slowed a and autthorities are doing their besst to maintain it on track. T The rec cent yuan move e has raised sp peculation thatt the Fed will n ow delay raising interest rates has weighed on th he dollar. The U US onomy should be able to withstand these e policy change eco es. Sho ould global con nditions further deteriorate, however, h the F Fed will act accordingly.
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Fed preparin ng for lift-off – 13 1 August 2015 5
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