Economists and the Federal Reserve officials are increasingly resolute that interest rates will rise in 2015, but markets are expecting rates to rise slightly later than they did last quarter. Conflicting portraits of the economy’s strength and the Fed’s determination to raise rates are leading to diverging opinions between economists and markets.
During Federal Reserve Chair Janet Yellen’s testimony to Congress on July 15, she restated a message that has been steadily becoming the conventional wisdom among the voting members of the Federal Open Market Committee (FOMC): The Fed will raise rates yet this year, and not wait until 2016.
[Hear: Axel Merk: The Fed May Raise Rates, But It Will Remain Behind the Curve]
To some this seems like an about-face for the dovish Yellen, but as she outlined during her testimony, the employment situation and employee cost index indicate the economy is strong enough to handle an initial increase—but that comes with the caveat that the overall pace of the interest raising cycle will be slow and measured.
Four out of five economists surveyed by the Wall Street Journal believe the Fed will raise rates in September, but markets are much less convinced by this timeline. Data suggests that market participants are still placing significant weight to rates being unchanged into the first quarter of 2016.
Markets Less Confident Than Three Months Ago
Even more interesting is that markets’ expected future Fed Funds rate is lower today than it was three months ago, despite Yellen’s more pressing rhetoric. This belief continues through March 2016, which is the longest-dated comparison the GRI analysis of the data provides for.
Source: CME Group and Global Risk Insights analysis
The question remains: why do market expectations differ so much from economists’ expectations — and why have the two moved in the opposite direction since the last meeting?
First, there are several economic indicators that simply paint different pictures of the state of the US economy. Lending credence to continued low rates are recent sluggish retail sales and manufacturing outlook data releases, and that inflation remains significantly below the Fed’s 2% target.
On the other hand, jobs growth is robust and the employment cost index is showing signs of coming wage growth. Essentially, the data can relatively reasonably justify a wide range of beliefs about the Fed’s timing.
The biggest difference between markets and economists’ outlooks is one of perception. The financial turbulence in Greece and China over the last month has had a much larger impact on US financial markets than on the broader economy. This explains why economists and the Fed have not been moved from their prior outlooks as much as market participants.
[Hear also: David Marsh: Global Institutions Investing to Escape the “Tyranny” of Negative Interest Rates]
The same difference between markets and economists could emerge next year as the Fed sets its pace for further rate hikes. The first interest rate increase is surely an important event, but the pace of subsequent interest rate increases will have a much larger impact on the economy. For traders, however, the first increase will have an outsized impact, and so it is conceivable that markets are placing a relatively larger importance on the first rate hike.
At a deeper level, markets’ disbelief of Yellen’s schedule may be due to a long memory. When then-Fed Chair Alan Greenspan telegraphed monetary tightening in 1996 with his irrational exuberance speech, markets pushed back and the Fed gave in to markets’ desire for low rates. A part of the collective mind of financial markets may believe this could happen again.
