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Wednesday, November 26, 2014

Fed Outlook For 2015

The upcoming year should see some monetary policy drama one way or another. What I see as a base case view - which appears to be a consensus position amongst economists at the time of writing - is that the Federal Reserve ("the Fed") will start to tighten around mid-year. However, the global economy is deteriorating, which poses the risk of derailing the tightening train. Since I do not have enough information to strongly support one outcome over the other, I will just give what I see are the best arguments for hawkish and doveish scenarios.

The Economic Backdrop

Chart: U.S. Nominal GDP Growth

What we have seen in 2014 appears to be  peak growth rates in the United States economy. In other words, any acceleration in growth is likely to be limited. Correspondingly, my "hawkish" scenario does not imply extremely rapid rate hikes.

Chart: U.S. Unemployment Rate

The key market in the United States is the labour market. There is a wide split in fortunes for different groups, with an unusually large amount of people dropping out of the labour force. However, widespread underemployment does not appear to putting downward pressure on wages in the hotter sectors of the economy. Therefore, the Fed will probably follow the signal of the Unemployment Rate, rather than the more muted Employment Ratio.

U.S. Wage And Consumer Price Inflation Trends

Core inflation (ex-food and energy) has been stable at a low level, and there is no sign that it will pick up in 2015. The Fed is only concerned about expected inflation; realised inflation will not move enough for it to become a factor in the Fed's decision making. (This is not a bold forecast; this has been true for the past 20 years.) Headline inflation (including energy and food prices) will follow oil prices; I will not hazard a guess what will happen to oil.

Baseline ("Hawkish") Scenario

The Fed will probably start hiking rates around mid-year, and raise rates by 25 basis points per meeting. (Reminder: a basis point is 1/100 of 1%.) That implies that the Fed Funds rate should be around 1% at year end 2015. There are a number of special factors that show up in this cycle.

  • No "Bang-Bang" Control. Janet Yellen has pulled "optimal control" out of the 1960s Control Systems Engineering closet, but she is unlikely to resuscitate the related field of "bang-bang" control. This was a philosophy within optimal control systems where you moved control variables as strongly as possible. (The deleterious effect on physical systems when this was attempted gave rise to the nickname.) In monetary policy terms, this means that the Fed will not immediately hike rates to a much higher level, such as 2%. (The economist Stephen Roach famously suggested such a policy move before the last hike cycle.) Instead, the Fed will follow its previous policy of"gradualism" with creeping 25 basis point rate hikes. 
  • Where will Fed Funds trade? The Fed has switched to having an upper and lower bound for the level of the Federal Funds rate, which is 0%-0.25%. If the market starts trading near the upper limit, we are starting 0.25%, not 0%. This may cause some confusion at the very beginning of the tightening cycle.
  • Quantitative Tightening? Will the Fed reverse "Quantitative Easing" (QE) by selling bonds (Quantitative Tightening, or QT)? My guess is that such a move would compound the bond market freakout that invariably accompanies the beginning of a rate hike cycle. My guess is that QT would start in 2016 at the earliest.
  • Boring technical arguments about instruments. The Fed will push up "risk-free" rates by raising the interest paid on excess reserves. However, divergences will open up amongst various interest rates that qualify as "risk free". The funding markets are important and usually ignored. When they seized up during the financial crisis, people found out the hard way how significant they are. That said, there is a tendency of experts to magnify every petty problem in those markets out of proportion. For technical reasons that I do not want to explain here, there will be a wedge between the interest rate paid on excess reserves and the Fed Funds rate. The gap will probably be on the order of a dozen basis points, possibly even up to twenty. This matters a lot for financial firms that fund in those markets; it will be completely irrelevant to customers' interest rates within the real economy. This will not stop people from claiming that "the Fed has lost control of interest rates!".
  • The Federal Reserve does not care about the Federal Government's interest costs.

The best argument in favour of a hawkish scenario is that inflation is not that low, and so that would indicate that there is not a lot of spare capacity in the economy. (This is using mainstream logic that I personally disagree with, but the Fed is nothing if not mainstream.) Moreover, with the policy rate at 0%, it will take two years of rate hikes (at the usual pace of 25 basis points a meeting) to reach a slightly restrictive level (at least on the basis of pre-crisis norms).

Doveish Scenarios

There are two main classes of doveish scenarios.

  1. Ultra-Doveish. Something derails the global economy and financial system before the Fed even raises rates one time; and
  2. Doveish. The Fed initially hikes rates around mid-year, but then stops when the policy rate is at a relatively low level. The Fed may additionally slow the pace of rate hikes.

I can think of many potential triggers for an "Ultra-Doveish" scenario.
  • Cascading defaults in China.
  • Falling oil prices causes a complete rout in the shale oil business, triggering high yield defaults by energy companies.
  • The Euro area periphery deteriorating even further, triggering a political backlash.
  • Foreign policy "mishaps".
At the time of writing, I view such an outcome as possible, but not high probability. Since I view the implications of Ultra-Doveish scenarios as being very straightforward ("Buy bonds!"), I will not cover them further here.

If we assume that the Fed starts hiking rates around mid-year, I do not see the path of the policy rate being different than my "hawkish" scenario in 2015. The Fed will not reach the terminal rate - the maximum policy rate reached during the tightening cycle - by December 2015, unless some cataclysm intervenes. Therefore, the trajectory of the policy rate in 2015 is the same in 2015 for both the "hawkish" and "doveish" scenarios. The difference in 2015 would only show up in the form of Fed communications - the Fed will hint that rates are going higher in the hawkish scenario.

The divergence would occur starting in 2016, and it would likely take the form of the Fed periodically pausing. A natural place to pause would be at policy rates that are round numbers - 1%, 1.5%, 2%, etc. For example, the Fed reaches 1%, and lets it be known that it will pause for 1-2 meetings before resuming. This will have the effect of slowing the pace of rate hikes. Eventually, the pauses get longer, and one of the"pauses" turns out to be the end of rate hikes.

While this is going on, the U.S. dollar will probably continue to strengthen, adding to the deflationary undertow to the economy. Financial markets may act in an even more deranged fashion, particularly if Treasurys enter a strong  bear market. This could act to short-circuit the tightening cycle even faster than what policymakers intend.

The arguments in favour of a doveish outcome either revolve around various vulnerabilities in the global economy, or the reality that there is considerable slack in the labour market (which is not measured by the Unemployment Rate). I am sympathetic to these views, but I am not a member of the Federal Open Market Committee.

Concluding Remarks

The line between the Doveish and the Hawkish scenario is fine, and it is not likely to be clear which side of it we are on until late 2015 or even 2016.

(c) Brian Romanchuk 2014


  1. An interesting post. Thanks.

    It reminds me of the 1991 book by Peter Schwartz "The Art of the Long View".

    As I write today, I hear that OPEC has decided to not support the price of oil. That should have several effects:

    1. The price of oil should fall until marginal producers (such as shale oil) stop expanding. Existing shale oil production should continue depending upon the strength of ownership.

    2. Oil consumers world wide will enjoy a reduced cost of oil based products. This reduction will be somewhat tempered by the reduction of new oil exploration efforts. The reduction will be further tempered by efforts to capture low cost supply for future buy-low sell-high resale. (Could be a better bet than buying gold.)

    3. Citizens in oil based economies will need to be more frugal. This could a major problem for Venezuela and other economies.

    4. The U.S. tax receipts should remain steady. Reduced taxes from oil efforts should be balanced with increased taxes from alternative spending. I have no feel for how labor demand will balance between less need for U.S. oil labor and increased consumer spending which should increase the need for labor in other production supply chains.

    5. If receipts and expenses stay steady, the present rate of money supply growth from government should stay steady. That would continue the present version of economic stability dependent upon the rate of money supply expansion.

    6. Bank borrowing may increase. A large swath of the U.S. economy will see a smaller "oil tax". If they still have a job, loans will be just a little easier to repay.

    A final "Long View" summary: For the duration of lower oil prices, jobs will shift from oil sector to non-oil sectors. A recovery of oil prices to recent levels will reverse the shift.

    1. Given the reaction of the bond market to the fall in oil prices, maybe I should have played up the doveish angle more before I published this. It is good for consumers, so it would normally be good for the economy. The wild card is that there has been considerable levered investment in shale oil production; the risk is that the unwind may cause more damage than the benefits for consumers.

      For Canada, this has been bad news as this could blow a hole in the exuberant housing market in Alberta (mainly in Calgary).


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