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The Federal Reserve is currently forecasting a “longer-term” Fed Funds Rate of 3.0%. Will they get there before the end of the current expansion? Let’s take look…
Given this backdrop, is 3% a realistic target before the cycle turns?
It doesn’t seem to be, unless a) the current expansion becomes the longest in history and b) the Fed significantly increases the pace of hikes, doing so against the expectations of market participants.
Observing the Fed’s behavior in recent years, this is unlikely. Their actual policy has been consistently more dovish than their own projected policy and much more in-line with the market:
What if the Fed starts surprising market participants with hikes in upcoming meetings? Again, this is unlikely as there hasn’t been a surprise interest rate move in the current cycle. In an effort to squash volatility, the Fed has telegraphed each and every move far in advance and always met the market’s dovish expectations:
If this pattern continues, and the Fed is going to meet dovish market expectations, it will be extremely difficult to get to their 3% long-term target. They are much more likely to move their projections lower than to meet them. The Fed has already moved their long-term projections down from 4.25% to 3.0%, and when they meet again in September we should not be surprised to see this trend to continue.
1) Reported inflation remains subdued, below the Fed’s 2% target.
2) The rest of the developed world continues to maintain an extraordinarily easy monetary policies, with negative real interest rates across the board.
3) Most importantly: the Fed has never once expressed any real concern about unintended negative consequences from keeping rates artificially low for so long. They have only expressed their steadfast belief that easy money has been exceedingly positive for household wealth (higher stock prices/housing prices) and the real economy (via the “wealth effect”).
While some market participants are fretting about another Fed-induced “bubble,” this the last thing the Fed is concerned about. Quite the opposite is true, as stated plainly by Ben Bernanke in an Op-ed back in 2010. They want higher asset prices:
“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
If there are no negative consequences to easy money, then easy money becomes the default policy. If higher stock prices only lead to higher confidence, increased spending, and higher income, then a forever higher stock market becomes the default target. Any time stock prices go down, you ease (ex: a new round of quantitative easing) or slow the pace of normalization.
In a model that is optimized for asset price inflation, this is perfectly rational behavior. The question is whether a model optimized for long-term real economic growth would look the same. Put simply, is easy money as good for the real economy as it is for the stock market? As we cannot prove the counterfactual (normalized monetary policy years ago), that’s a question that can never really be answered. Which is another reason why the Fed is likely to continue to error on the dovish side, as they can take all of the credit for positive outcomes while arguing that any negative outcomes would be far worse but for their heroic easy money policies.
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Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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