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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. Important Information Published on 26 June 2015. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. This material is for informational purposes only. It is not intended to, and does not constitute financial advice, fund management services, an offer of financial products or to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai International Financial Centre 0467. 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