Fed policy is driven by two factors
Following heavy hints from members of the Federal Open Market Committee, financial market participants are pricing in a rapid tightening of US monetary policy. But how much faith should we have in these predictions? It is easy to forget that on several occasions in the last 15 years the Fed has changed tack very sharply in response to changing news and data and cut interest rates by dramatic amounts.
For instance, while interest rates in the summer of 2007 stood at 5.25%, a year later they had been cut to 2%, and by early 2009 they were down to 0.25%. Plainly no market participant expected in July 2008 that the Fed would have cut interest rates by 525 basis points in 18 months’ time.
Such episodes demonstrate that it may be useful to think of Federal Reserve interest rate policy as consisting of two components.
The first of these can be thought of as the normal evolution of monetary policy. This involves the Fed gradually changing interest rates in response to shifts in the outlook for inflation and the labour market. This part is generally well anticipated by financial market participants.
The second comprises very large and rapid changes in interest rates in response to entirely unanticipated events that have huge ramifications for economic conditions. Many market commentators appear to disregard them and therefore tend to underestimate the uncertainty of future interest rates.
The information in fed funds futures contracts
Our analysis suggests that investors are very certain about the outcome in June and July, viewing them as “done deals.” But from September onwards there is growing uncertainty about what rate the Fed will set. For instance, the probability that the Fed will have raised interest rates by less than 175 basis points by September is 42%, and the probability that it will raise interest rates by more than 175 basis points is 10%.
Another way to illustrate the uncertainty is to compute the probability distribution for the federal funds rate at the different Fed meetings as perceived by market participants. The estimated probability distributions, which disregard the June and July meetings for which market participants have very firm views, are instructive.
They show that investors view interest rates anywhere between 2.25% and 2.75% are plausible for the September meeting, as are interest rates between 2.5% and 3.25% for the November meeting. For the December meeting, interest rates between 2.75% to 3.75% are likely. For the May 2023 meetings, they view interest rates between 3% and 4.25% as possible. These are very wide ranges.
The main conclusion from this analysis is that there is marked uncertainty about what interest rates the Fed will set over the coming year, except for the next two meetings. While these results pertain to the Fed, similar uncertainty is likely to apply to the outlook for interest rates for other central banks.
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