Download Beyond Lift-Off Scenarios for the Federal Funds Rate

Investment Research
Beyond Lift-Off
Scenarios for the Federal Funds Rate
Ronald Temple, CFA, Managing Director, Portfolio Manager/Analyst
David Alcaly, Research Analyst
With the US Federal Reserve poised to begin raising interest rates for the first time in nearly a decade, the timing of
“lift-off” is the subject of intense scrutiny. We think the Fed should wait until 2016 to allow for clearer signs of labor
market tightening and stronger inflation before acting. However, we expect that the first rate hike is likely to happen
this year and that the subsequent trajectory of rate hikes will be much more important than the timing of the first one.
In this paper, we examine three scenarios for rate increases and discuss their implications for markets.
2
Introduction
It has been almost seven years since the US Federal Reserve’s (the Fed)
Federal Open Market Committee (FOMC) cut the federal funds rate
target range to 0%–0.25%. Now, investor expectations for “lift-off,”
or the date when the FOMC begins raising rates, range from as early
as September 2015 to as late as March 2016. While the timing of liftoff is interesting, we believe that the subsequent pace of rate increases
and the level rates reach are even more important topics.
We continue to believe that the FOMC should wait until 2016 to
begin raising rates, based on our assessment that a substantial excess
supply of labor remains. Our latest estimate is that the United States
needs to create between 2.2 and 4.8 million jobs to absorb this slack,
a process that could take anywhere from 13 to 24 months, assuming
the United States can create 225,000 to 275,000 jobs per month.
Nevertheless, a number of recent speeches by voting FOMC members
indicate that lift-off may well occur in 2015. We think it is important
to point out that raising rates by 25 basis points (bps) or even 50 bps is
not likely to substantially affect the growth rate of the US economy or
the pace of labor market healing. In fact, this may be the belief of the
many FOMC members who want to get off the zero lower bound and
begin the process of normalizing monetary policy.
In this paper, we examine three scenarios for lift-off, the pace of rate
increases, and how high rates might go in this tightening cycle. Clearly
there are “infinite” potential scenarios, but we have identified probable
scenarios that allow us to assess investment implications.¹ Similarly,
for the sake of succinctness, we have opted to set aside the muchdebated longer-term question of whether future potential economic
growth has been reduced, as proponents of the “secular stagnation”
theory believe, as well as the topic of potential future reductions to the
size of the Fed’s balance sheet.
back to previous tightening cycles or inflationary episodes. We note
our scenarios are to the dovish side of FOMC median projections and
roughly in line with futures markets, as can be seen in Exhibit 2. While
we recognize the directional importance of the FOMC’s Summary of
Economic Projections (SEP), we do not believe that FOMC forecasts
are terribly predictive of the future course of rates because they are
based on each FOMC member’s assumption that an ideal policy path
is pursued and that the economy responds as expected. This framework
is, in our view, unrealistic both because 1) individual views on the
policy path and the economy differ; and 2) because the framework to
some degree contradicts the “data dependence” of monetary policy.
Exhibit 1
The Effective Federal Funds Rate Is Likely to Remain
Extremely Low by Historical Standards
(%)
24
18
12
6
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Recession
Nominal Effective Fed Funds Rate
Core PCE (YOY Change)
As of April 2015
Source: Federal Reserve Board, Bureau of Economic Analysis
Scenarios
Our scenarios present the range of what we consider to be the most
likely paths for the federal funds rate target range. As such, we focused
on when the FOMC may begin to increase rates, a general pace for
subsequent rate increases, and the target range two years from now.
The box titled Scenario Analysis for the Federal Funds Rate (page 4)
outlines these scenarios and their likelihood, as well as the rationale for
and implications of each, but in brief:
• Base case: lift-off takes place at the December 2015 FOMC meeting and the federal funds rate target range reaches a 2% upper
bound by mid-2017.
• Hawkish case: lift-off takes place at the September 2015 FOMC
meeting and the federal funds rate target range reaches a 3% upper
bound by mid-2017.
• Dovish case: lift-off takes place at the March 2016 FOMC meeting and the federal funds rate target range reaches a 1.25% upper
bound by mid-2017.
These scenarios all imply that rates will remain extraordinarily low by
historical standards, as shown in Exhibit 1.
It is important to note that there is no parallel in US history for the
current monetary policy. Hence, we do not find it instructive to look
Exhibit 2
Our Federal Funds Rate Scenarios Are Roughly in Line with
the Market
(%)
3
2
1
0
Jun 15
Dec 15
Jun 16
Dec 16
Jun 17
Dec 17
Hawkish Case
Base Case
Dovish Case
Median FOMC Projection from Latest Assessment
Federal Funds Futures Implied Effective Federal Funds Rate
As of 17 June 2015
The median FOMC projection for the Fed Funds Rate in the longer term is 3.75%.
Estimated or forecasted data are not a promise or guarantee of future results and are
subject to change.
Source: Bloomberg, Federal Reserve Board, Lazard
3
One important implication of our relatively dovish scenarios is that
they do not leave a lot of dry powder—in the form of the ability to
use interest rates as a policy tool—for the FOMC in the next business
cycle. This lack of tools increases the likelihood that the FOMC will
need to resort to quantitative easing (QE) and other unconventional
measures and that the Fed’s balance sheet may not return to its precrisis size, implications that the FOMC no doubt might wish to avoid.
Progress on the Dual Mandate
As the FOMC has repeatedly reminded markets, its decisions ultimately are dependent on incoming data. However, as implied by
our scenarios, we believe that considerable ambiguity remains on
how close the FOMC is to achieving its dual objectives of maximum
employment and 2% inflation, and over how the economy will react
to monetary policy tightening.
The labor market has made significant progress since the crisis, with
momentum accelerating in 2014. Over the past year, the United States
added 3.1 million nonfarm payroll jobs with an average of 207,000
jobs per month over the past three months. Similarly, the unemployment rate dropped from 6.6% at the beginning of 2014 to 5.5% in
May 2015, nearing the central tendency of the FOMC forecasts for
the longer-run unemployment rate of 5.0%–5.2% from the June SEP.
However, as we discussed in our Investment Research paper,²
Estimating US Labor Market Slack, the unemployment rate only
covers unemployed individuals who have looked for work in the past
four weeks and are thus considered part of the labor force. Other
metrics that capture levels of under-participation in the labor force
or underemployment remain further from pre-crisis levels, including
our preferred indicator, the employment-population ratio (E/P ratio),
which measures the number of employed against the total employable
population. Updating our calculations from December 2014, which
adjust the E/P ratio for the aging of the workforce and increased disability claims, we estimate that as of May 2015 a jobs gap of 2.2–4.8
million jobs remained, with a gap of 3.5 million jobs as our base case
(Exhibit 3). Even with optimistic assumptions about the pace of jobs
growth and the number of these jobs that ultimately are filled, this gap
could take roughly 13 to 24 months to close.
Adding to ambiguity about the health of the labor market is persistently weak wage growth. The two most commonly cited indicators,
average hourly earnings (AHE) and the employment cost index (ECI),
have both shown year-on-year rates of change around 2% for much
of the past two years, well below the level required to keep up with
the FOMC’s inflation target plus the long-run rate of productivity
growth. However, both measures have shown mild improvement
recently. In May, the year-on-year change in AHE, which captures
not just changes in wages but also changes in the overall composition
of high- and low-wage jobs, rose to 2.3%. In the first quarter of 2015,
the year-on-year change in ECI for wages and salaries, which corrects
for changes in the composition of jobs, jumped to 2.6%, although
when incentive-paid occupations are excluded it was a more pedestrian
2.0% (Exhibit 4). For her part, FOMC Chair Janet Yellen has cited
evidence that wages have a stronger historical relationship with factors
other than labor market conditions, like productivity growth, and said
that for this reason stronger wage growth is not a prerequisite for lift-
Exhibit 3
Estimated Labor Market Slack
Employment-to-Population Ratio (%)
66
63.4%
Dec 2006
63
10.1M
jobs
60
59.4%
May 2015
57
54
1949
1963
1976
1989
2002
2015
Sizing the Jobs Gap
Peak E/P Ratio (%)
Dec 2006
Implied Employment at Peak E/P Ratio (Millions)
63.4
158.9
May 2015
10.1
Aging (Millions)
May 2015
4.2
Disabilities (Millions)
Apr 2015
1.1
May 2015
4.8
Jobs Gap (Millions)
Explained by
Unexplained Jobs Gap (Millions)
Unexplained Jobs Gap if “True” Peak E/P Ratio Is Lower than Dec 2006
Base Scenario (Millions)
(62.9% E/P Ratio)
3.5
Low Scenario (Millions)
(62.4% E/P Ratio)
2.2
As of May 2015
Estimated or forecasted data are not a promise or guarantee of future results and are
subject to change.
Source: Bureau of Labor Statistics, Lazard
Exhibit 4
Wage Growth Improving?
YOY Change (%)
4
3
2
1
Recession
0
2007
2009
2011
2013
Average Hourly Earnings (Total Private Industries)
Employment Cost Index for Wages and Salaries (Civilian Workers)
Employment Cost Index for Wages and Salaries (Civilian Workers,
ex Incentive-Paid Occupations)
Average hourly earnings as of May 2015.
Employment cost index is disaggregated quarterly data as of March 2015.
Source: Bureau of Labor Statistics, Lazard
2015
4
Scenario Analysis for the Federal Funds Rate³
Base Case 50% probability
Trajectory
Hawkish Case 35% probability
Dovish Case 15% probability
• Lift-off at the 16 December 2015 FOMC
• Lift-off at the 17 September 2015 FOMC
• Lift-off at the 16 March 2016 FOMC meetmeeting, with the federal funds rate target
meeting, with the federal funds rate target
ing, with the federal funds rate target
range set to 0.25%–0.50%.
range set to 0.25%–0.50%.
range set to 0.25%–0.50%.
• The FOMC continues to emphasize that
• Subsequent rate increases follow a cau• Subsequent rate increases follow a very
future increases will be “data dependent
tious path at first before accelerating later:
slow and cautious path: 25 bps at every
to avoid undermining the economic recov25 bps at every other FOMC meeting
3 to 4 FOMC meetings, with elevated
ery. Subsequent rate increases follow
through mid-2016 and then each FOMC
chances of extended pauses.
a cautious path: 25 bps at every other
meeting through mid-2017.
• By mid-2017, the federal funds rate target
FOMC meeting.
• By mid-2017, the federal funds rate target
range reaches 1.00%–1.25%.
• By mid-2017, the federal funds rate target
range reaches 2.75%–3.00%.
range reaches 1.75%–2.00%.
FOMC Rationale
• The developed world remains saddled with • The FOMC believes labor market slack is
extraordinarily high levels of debt. Weak
both overestimated and diminishing, and
real GDP growth and low inflation rates
recognizes lags in monetary policy. It also
slow the deleveraging process, forcing the
believes weak inflation is due to “transiFOMC to remain accommodative.
tory” factors and that weak wage growth
is more driven by factors outside its con• Lift-off reminds markets that 0% is not
trol, like productivity growth.
the normal federal funds target rate. The
gradual pace of rate increases keeps real
• The FOMC is eager to get off the zero
rates at or slightly below 0% in recognition
lower bound and, having guided investors
that deleveraging is not over.
to expect lift-off in 2015, wants to meet
expectations to avoid destabilizing global
• The FOMC recognizes labor market slack
markets. It sees potential benefits in:
but believes it will diminish. Similarly, the
FOMC is concerned by weak inflation but
“reasonably confident” that it will eventually accelerate.
• The FOMC also wants to protect against
future blame for a potential bubble in
fixed income markets. Raising the target
rate by 25 bps and then following a slow
path shows it is aware of risks to financial
stability.
Implied Economic
Conditions
• The FOMC shares our point of view on
labor market slack, especially given disappointing wage growth. Some members
place added emphasis on the need to draw
people back into the labor force.
• Low inflation rates, particularly in a globally
weak environment, are a significant concern and the chances of overheating are
slim. The FOMC wants to be sure that this
–– Signaling its view that the US economy
weakness is “transitory” and prefers “seeis healthy; and
ing the whites of inflation’s eyes” over
–– Reminding markets that rates won’t be
continuing to miss its target.
zero forever.
–– Getting past a milestone that has created high levels of anxiety;
• The actual changes in rates are still relatively small and monetary policy will still
be accommodative for some time, giving
the FOMC confidence that it won’t derail
the recovery and that it will have tools to
combat inflation.
• Economic growth decelerates, though not
• Economic recovery resumes the pace
to the point of a recession. Similarly, the
observed in the second half of 2014, while
net absorption of excess labor slows and
concerns over weaker growth seen in the
first quarter of 2015 and the impacts of a
wage growth remains weak.
• Labor market slack slowly diminishes,
• Inflation remains stubbornly low, forcing
while wage growth remains weak well into stronger dollar recede.
the FOMC to begin contemplating other
the hiking cycle.
• The labor market shows clearer signs
extraordinary measures to achieve its
• The inflation rate slowly trends toward 2%, of tightening and stronger wage growth
gradually materializes.
target.
remaining subdued.
• Economic growth remains uninspiring,
with real GDP growing about 2% per
annum.
• Confidence increases that inflation is
returning to 2% and has been weighed
down by the transitory impacts of low
energy prices and a strong dollar.
Investment
Implications
• Extraordinarily high levels of debt and slow
deleveraging are weighing on economic
activity and the FOMC wants to be very
cautious about rate hikes to ensure that
the economy can handle the higher debt
service burden.
• There is sustained weakness in the global
economy, as well as elevated deflationary
pressures.
• Yield curves flatten as investors realize
• Meaningful downside risk in long-duration • Increased urgency in the search for
that the effective federal funds rate is likely fixed income instruments.
yield drives investors to longer-duration,
to be around 2% deep into the recovery.
riskier fixed income instruments. Good for
• FX volatility could increase substantially
Good for income-producing alternatives.
income-generating equities and income
as investors adjust their expectations to a
alternatives.
• FX volatility remains relatively low, as the
more hawkish trajectory.
FOMC moves at roughly the pace antici•
FX volatility could decrease in G3 curren• Equity markets could face downside risk
pated by markets.
cies as monetary policy is not as divergent
as investors question the appropriate
as anticipated. Emerging markets curren• A “permanently” lower discount rate could discount rate for future cash flows. This
lead to higher valuations, but the implied
could be somewhat balanced by a stronger cies could rally as a “Taper Tantrum Part
2” will not be realized.
weakness of the recovery could lead
economic outlook, especially if momento lower revenue growth expectations.
These factors could create a “barbell,”
with growth stocks achieving even higher
valuations and high-dividend-yield stocks
also rising in value. More highly leveraged
companies could underperform in recognition that the “free money” era is over,
though the impact would be limited by the
still-low level of rates.
tum builds in consumption and housing.
• Equity markets could benefit as investors
Active managers could benefit as winners
reassess future discount rates and realize
from the period of exceptionally low rates
that stocks trading at a forward P/E ratio
become the relative losers in an environof 16–18 times, often with dividend yields
ment of increasing rates.
well above sovereign debt yields, are a
relative bargain.
5
2%. A weak global environment may put pressure on US inflation for
some time, and we believe the FOMC will—at a minimum—want to
ensure that: inflation does not deteriorate further, various measures of
expectations remain steady, and then inflation actually begins to grow
more strongly as the labor market presumably tightens.
Exhibit 5
Inflation Remains Subdued
YOY Change (%)
3
Core PCE
Conclusion
2
1
Recession
0
Jan 01
Nov 03
Sep 06
Jul 09
May 12
Mar 15
As of April 2015
Source: Bureau of Economic Analysis
off, although weaker wage growth would make her “uncomfortable.”
Nonetheless, a sustained acceleration in wage growth would provide
significant confidence that the jobs gap is closing and would contribute to a stronger recovery via rising income and higher inflation.
Similarly, the FOMC’s preferred measure of inflation, the year-onyear change in the personal consumption expenditures price index less
energy and food (core PCE) has been below the FOMC’s target of 2%
for 76 of the last 79 months, and stood at 1.2% in April 2015 (Exhibit
5). In recent comments, the FOMC has attributed current weakness to
the “transitory effects” of low oil prices and a strong dollar and pointed
to relatively consistent survey-based measures of inflation expectations to support its belief that inflation will return to its target in the
medium term. It has however, hedged this view somewhat by asserting
that while it is willing to raise rates at the current pace of inflation, it
needs to be “reasonably confident” that the inflation rate is heading to
As we near the FOMC’s first rate hike in almost a decade, attention is
understandably focused on its timing. While we believe the FOMC
should wait until 2016 to allow for clearer signs of labor market tightening and stronger inflation, we also recognize that lift-off is likely
to happen this year and that the subsequent trajectory of rate hikes is
likely to have much greater importance for the economy and investors
than the first 25 or 50 bps. In order to consider the differing impacts
of probable rate trajectories, we have outlined three scenarios that we
believe bound the most likely possibilities, given the ambiguity over
how close the economy currently is to the FOMC’s dual mandate and
over how it will react to rate hikes.
In all three scenarios, we expect the US economy to continue growing at a relatively moderate pace with varying degrees of labor market
improvement. We also see two of the three scenarios as relatively
benign for investors in equities and fixed income. It is only in our
hawkish scenario that we see more volatility arising as the market is
currently pricing a path that is meaningfully different from this case.
Regardless of which scenario ultimately unfolds, we continue to focus
our bottom-up research on identifying securities that we expect to
outperform based on their company-specific drivers. We continue to
believe that the best investments are in shares of companies that have
strong balance sheets, robust organic cash flow growth, and the operational flexibility that arises from these characteristics, thus allowing a
company to navigate the twists and turns of monetary policy.
Notes
1 We note that our three scenarios could change as the economy and markets react to FOMC actions. In particular, timing and communication early in the policy normalization cycle will be critical for the FOMC, due to the potential for markets to overreact. To draw an extreme example of overreaction, if the FOMC raises rates at two consecutive meetings and investors assume
that tightening will continue at every meeting for an extended period of time, it could lead to a sharp steepening of the yield curve, a spike in the value of the US dollar and a sell-off in equities
that undermines the very recovery that was the catalyst for the FOMC to act.
2 Paper available at: http://www.lazardnet.com/investment-research/
3 Information and opinions are as of June 2015 and are subject to change. Estimated or forecasted data are not a promise or guarantee of future results and are subject to change.
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Published on 26 June 2015.
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