Central bank rates one year from now...FF up 52 bps

Tuesday, September 22, 2009

The core inflation rate has dropped to 1.4%, while the unemployment rate surged to date. And barring some unforeseen and positive economic surprise, like renewed confidence driving consumer spending more quickly than anticipated, these variables that define the Fed's dual mandate are likely to remain outside the Fed's comfort zone into next year. Therefore, policy is likely to be quite expansionary in the foreseeable future (which in forecasting terms, that is 2010). But how far into the future; and what will be its exit strategy?

I just wanted to chime in on this issue of Fed exit strategy, specifically with rate hikes (or, as some of you will properly identify, target rate hikes). The Fed has a ton of policy to unwind, over a $trillion in direct asset purchase: >$800 in billion MBS, soon to be $300 billion in Treasuries, and soon to be $200 billion in agency debt. Furthermore, the Fed dropped its target rate (the federal funds rate, ff rate) to practically 0%. Therefore, there are several permutations of exit strategy to consider. Here are the main ones:

  1. The Fed unwinds the assets first, and then raises its target rate
  2. The Fed unwinds its assets after raising its target rate
  3. The Fed mixes exits: unwinding assets while contemporaneously raising its target rate
Timing is key here, and NOBODY expects the Fed to raise tomorrow. The Fed will monitor financial markets and the economy, and decide which action is appropriate. But given the obvious interdependence between financial markets and the economy, my bet's on a contemporaneous rate hike and asset sell-off. But let's be real, even the Fed hasn't mapped out its exit strategy in full.

The MBS market is tricky. Unless the housing market is plugging away, it will be difficult for the Fed to inundate the MBS market with its very huge supply of MBS (11% of the market as of June 2009, and counting). Therefore, it is likely that the Fed exits in a more weighted way: more quickly selling off assets, but also raising its target rate.

According to Morgan Stanley and the overnight indexed swap curve, the Fed’s target rate is expected to be just 52.9 bps higher than it is today (see cum in the chart below) in June 2010, or about 0.75%.

Given that consensus expects the unemployment rate to be in the 9%-10% range by then, I’d say that 75 bps is more of an upper bound. Unless inflation gets a push forward – at the core level, this is very unlikely given the long lags in price fluctuations – the economy will be just too weak. The decline in all measures of prices (including wages) will keep inflation very much in check, with some upside risk on the back of emerging market growth and energy price gains.

So there you have it. Is the market correct? 75 bps next year? That's still a lot of stimulus left in the system.

Rebecca Wilder


Flow5 September 22, 2009 at 1:34 PM  

It's ludicrous to assume that the FED has a dual mandate. The FED can only control inflation, and they aren't very good at that. Look to Congress and our legislators to help solve our unemployment problems.

With Federal Deficit financing it is probable to me that "excess reserves" will continue to grow. I.e., the FED could float the entire federal deficit, for say 1 year, by increasing excess reserves. I.e., there is no exit.

Maybe there will be a return to the Treasury's Supplemental Financing Program. Foreigners are fed up. Crowding out is likely. & people are ignoring the interest expense on the Federal Debt.

With the Democrats and socialists at the helm the American people are in trouble.

fajensen September 23, 2009 at 5:39 AM  

With the Democrats and socialists at the helm the American people are in trouble.

Help me out here: In precisely what way - apart from the president being black - is the Obama administration behaving differently from the Bush ditto?

The FED cannot raise rates because that would blow up all those over-leveraged positions that the FED helped keep alive.

In my opinion the FED's exit strategy is to somehow force a default on the USD-denominated debt - not exactly like Russia did because the US will not take any responsibility so Someone Else, Unforeseen Circumstances, Dark Forces, Ming The Implacable must do the deed.

The difficult part of the exit plan is that it will take *a lot* of insane government deficits, printing, bailing and maybe a good dollop of downright securities fraud before the Chinese will drop their USD addiction so that is precisely the behavior we will see for as long as it takes.

Mr Obama has an advantage here: The Democrats mantra of "Embrace whatever stupid thing the Republicans started and then Expand & Embellish it" will serve them well ;-)

JKH September 23, 2009 at 10:46 AM  

To borrow from Greenspan's original language, balance sheet normalization will occur at "a measured pace", probably in parallel or at least overlapping with interest rate tightening.

Of the two, timing of interest rate increases is far more critical than balance sheet normalization. The current balance sheet effect is pretty much immunized by paying interest on reserves - an interest rate that will increase in tandem with the fed funds rate.

Flow5 September 23, 2009 at 11:47 AM  

difference is that Bush understood what he was doing. Obama doesn't have a clue. that's why he was called a liar.

health care is a very good example and it's more significant from the standpoint of the economy than anything Bush did.

we need tort reform similar to what Mississippi has enacted. Obama is a lawyer and is prejudiced.

we need standardized documentation, and not one set of standards for the docs to fill out for each insurance company

insurance companies are allowed to change their coverage without any lead time. they use the internet and apply the changes at the same time. etc.

Flow5 September 23, 2009 at 11:50 AM  

This is the future:

Paying Interest on Reserve Balances:

It's More significant Than You Think

Flow5 September 23, 2009 at 12:01 PM  

and I forgot to mention taxes

spencer September 24, 2009 at 9:46 AM  

very good

Flow5 October 16, 2009 at 9:18 PM  

"WASHINGTON (MarketWatch) -- THE DOLLAR IS NOT A TOOL THAT U.S. POLICYMAKERS USE,Dallas Federal Reserve President Richard Fisher said Friday"

The U.S. has accumulated a 7.4 trillion dollar current account deficit. This compares to a 12 trillion dollar federal budget deficit. It should be obvious, the FED's mandate excludes the exchange value of the dollar.

It should also be obvious that the FED's mandate does not include targeting the unemployment rate.

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