The big debate in financial markets over Federal Reserve policy is no longer about when officials will raise interest rates but about how high they will go.
Investors and economists disagree on whether the Fed’s tightening cycle -- expected to begin on Wednesday -- peaks somewhere in the 2 percent range or lower, versus 3 percent or higher. All but three Fed officials, as of September, estimated the benchmark lending rate would be between 3 percent and 4 percent at the end of 2018. Market rates reflect investor skepticism: the 10-year U.S. Treasury note currently yields 2.2 percent.
The debate reflects unresolved questions about the U.S. economy more than six years after the expansion began. Why has worker output per hour slumped and will it come back? Can more working-age Americans be tempted back into the job market? Will U.S. wages accelerate at a faster pace?
“You should see a stronger global economy, you should see more credit creation and stronger housing,” said Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York, who expects the policy rate to peak around 3.25 percent in 2018.
Robert Brusca, the head of Fact & Opinion Economics in New York, called such outlooks a “happily ever after” story that ignores the potential for further gains in the dollar to hurt trade and manufacturing. “I feel more comfortable in the 2 percent camp,” he said.
Liftoff Meeting
Just how the debate resolves has big implications for Americans households and businesses who borrow, as well as investors around the world. The policy-setting Federal Open Market Committee is scheduled to release its decision at 2 p.m. Wednesday in Washington, and investors see a 78 percent probability it will lift rates by a quarter percentage point from near zero.
Fed officials projected their policy rate at 3.4 percent at the end of 2018, according to their median quarterly estimate released in September. Eurodollar futures -- another indicator of where short-term rates are headed -- are currently pricing three-month money at around 2 percent by that time.
“It is very important to get this right, and to know if the central bank is not getting it right,” Brusca said. “It matters to people who buy bonds and it matters to people who invest in stocks.”
Neutral Rates
Stripped to essentials, the question over how high rates need to go in this cycle is really about what interest rate the economy needs in the longer run to balance supply and demand.
Fed officials considered that question during a staff briefing on the “equilibrium” real rate at their October meeting. It’s important because if the Fed overshoots that rate, the economy could slow, and if it undershoots it could lead to another bubble or possibly inflation above their 2 percent target.
In the short run, the staff concluded, this equilibrium inflation-adjusted rate was estimated to be “close to zero currently,” the minutes of the meeting said. Right now, the real fed funds rate is around minus 1.2 percent, which is why Fed officials say policy will remain accommodative even if they raise interest rates this month.
Longer Run
Over the longer run, Fed officials estimated the rate at 3.5 percent, or 1.5 after subtracting for 2 percent inflation, according to their median estimate in September.
Their estimates are likely to fall further in the December forecasts that will be published Wednesday, said Andrew Levin, a Dartmouth College professor and former Fed Board staff member who advised then-Vice Chair Janet Yellen in 2012 before she became chair.
“I wouldn’t be surprised if the central tendency clusters around 3 percent, about half a percentage point lower than in September,” Levin said in an interview. “By next June, they will probably revise further and write down numbers like 2.5 percent.”
Such revisions could validate current rates in the Treasury market and keep yields low. Forecasts involve a mixture of judgments about everything from investment to labor force growth. Here’s a summary:
The 3 Percent Case
Falling Unemployment: Many economists in the 3 percent camp foresee further declines in the unemployment rate from 5 percent in November. Both JPMorgan Chase and Macroeconomic Advisers in St. Louis forecast the jobless rate will decline by about another half percentage point by the end of 2016.
King Consumer: Tightening labor markets lead to better pay, stronger household spending and higher demand that will gradually push inflation up toward the Fed’s 2 percent target. Consumption has averaged 2.3 percent in this expansion compared to 3.1 percent in the five years before the recession.
Productivity: Output per hour is a critical component in estimates of how fast the economy can grow. Lately it has slumped, averaging just 0.5 percent over the past four quarters on a year-over-year measure. That compares with average labor productivity growth of 2.3 percent a year in the 20 years before the 2007-2009 recession, according to JPMorgan Chase.
Low rates of productivity are one reason why unemployment will continue to fall, according to some forecasters. But eventually they see it moving higher. Michael Feroli, JP Morgan’s chief U.S. economist, sees labor productivity accelerating to 1.3 percent in 2016, contributing to the firm’s 1.75 percent estimate for potential growth. “Some reversion toward longer-run averages seems likely,” Feroli said in a note to clients.
The 2 Percent Or Lower Case
Shocks: One possible explanation for low market rates now is that investors are pricing in the risk of a recession or some other shock that slows growth.
“We expect to see growth slow and financial conditions tighten more than the Fed anticipates,” said Laura Rosner, U.S. economist at BNP Paribas in New York, who expects the fed funds rate to crest at 2.25 percent in March 2018.
Stagnation: Productivity continues to slump, unemployed people of working age don’t reenter the labor force, and both consumers and businesses remain cautious, curbing spending and investment.
“If you think productivity is going to stay at half a percent, you are looking at real rates of growth of 1 percent to 1.5 percent,” said Priya Misra, head of global rates strategy at TD Securities LLC in New York, who estimates that the fed funds rate will peak at around 2 percent in this cycle. “That is a pretty negative state of affairs.”
Inflation: U.S. central bankers have been under their 2 percent target for more than three years.
Guy LeBas, a managing director at Janney Montgomery Scott LLC in Philadelphia, said inflation performance will become central to future rate decisions. If the economy has fundamentally disconnected from that target in some way, there is little reason for the benchmark lending rate to go above 3 percent.
“We can’t say what causes inflation anymore,” said LeBas, who sees the fed funds rate peaking at 1.5 percent in 2017. “The theoretical preconditions for inflation are mostly there,” he says. “But the actual inflation is not.”