Federal
Reserve projections point to a federal funds rate of close to 3% in 2017
Central Bank Watch
My sense is that the Federal Reserve (Fed) will raise the federal (fed) funds target rate by 0.25% to 0.50% by the end of the year.
A key question is why would the Fed begin to target a higher fed funds rate when according to the central projections of the members of the Federal Open Market Committee (FOMC) inflation is expected to remain below its target of 2% this year, and even in 2016.
The key to understanding this is the real interest rate. Typically, the Fed targets a real interest rate of 1.5 to 2%.
The financial crisis of 2008 led to sharp declines in output. In response to the crisis, the Fed cut interest rates to virtually zero (the targeted fed funds rate is today between 0 and 0.25%), and engineered a massive quantitative easing programme, i.e. pushed money into the hands of banks by buying bonds by printing money (electronically).
What worried the Fed was the fact that the recovery in the economy after the crisis was accompanied by low levels of inflation. This raised the spectre of deflation - a secular decline in prices - which could be damaging to the long term growth of the economy. Since 2010, the level of inflation has consistently stayed below 2%. The Fed is of the view that 2% is a healthy level of inflation for the US economy, reaching close to full employment, and growing at 2-3%.
Hence, by keeping fed funds at 0% the Fed has tried to grow and inflate the economy with a negative real rate of about -1.5% (fed funds at 0% less inflation at 1.5%). The Fed's quantitative easing has been another weapon in this endeavour.
Now going by the FOMC’s projections of inflation let’s assume that inflation does rise back to 2% in 2017. Under normal times, if the inflation rate is 2%, the fed funds rate should be about 3.5%. Hence the Fed has to raise the fed funds rate by a huge 3.5%.
This it cannot do without creating major dislocation both in the financial markets and in the real economy. So the Fed has to start taking baby steps to raise the fed funds rate well in advance.
A look at the projections of the FOMC members accompanying the FOMC statement after its June 16-17 meeting supports this view. As per the projections, the median level of the fed rate by end of 2015 is 0.625%, by end of 2016 it is 1.625% and by end of 2017 it is 2.875%.
Another takeaway is that even
after the Fed sees inflation at the 2% level, and employment is somewhat close
to the full employment level, the Fed will keep the target for the fed funds
rate below a level that it considers "normal in the longer run".
Hence a projected rate of 2.8% in 2017, when as per the Fed's real interest
rule the target funds rate should be about 3.5%.
Finally, the FOMC statement reiterates that the Fed will continue with its bond buying programme, as the proceeds of bonds maturing in the Fed's portfolio will be rolled over. The Fed will continue with its unprecedented quantitative easing programme!
What does this mean for investors in India?
In the near term, the Fed’s decision to hold the target fed funds rate at the present level will support the capital markets. I
In the medium term, however, portfolio
capital is likely to move out of India and the rupee will be under downward
pressure - unless India improves it governance, goes in for further reforms,
and raises productivity, both in the public and private sector. In such an
environment, stock selection gains more importance - so steady profits, low
debt, and trust appear to be key factors in generating returns.
