Magazine article Economic Trends

Money and Financial Markets

Magazine article Economic Trends

Money and Financial Markets

Article excerpt

An inflation-adjusted overnight interest rate near or below zero is not thought to be sustainable without ultimately inducing inflationary pressures. Thus, the Federal Open Market Committee (FOMC) will eventually need to raise the federal funds rate to a more neutral level. The language of the FOMC's June 30 meeting indicated that the Committee would do whatever was required to maintain price stability, but given current economic conditions, it anticipated that the fed funds rate could be increased at a "measured" pace.

At press time, the market-implied probabilities suggested that the most likely outcome of the August FOMC meeting would be a 25 bp hike. This outcome was consistently viewed as the most probable during the entire intermeeting period. At the time of the June 30 meeting, the probability of a 50 basis point (bp) hike was about one in three, but it rapidly declined. The probability of no change hovered around 10% throughout the intermeeting period.

Looking toward the September meeting, options on October fed funds futures contracts reveal that markets anticipate the FOMC is likely to choose a 1.75% fed funds rate target. Thus, two hikes of 25 bp each were viewed as the most likely outcomes of a "measured" pace for policy through the summer months. Despite the decline over the intermeeting period, a 2% target, involving a 50 bp hike at one of the next two meetings, was given a 20% probability.

Short-term Treasury rates rose substantially in the spring, consistent with the steepening funds rate trajectory in May, but stabilized during the summer. Long-term rates also rose but backed off recent highs after the initial run-up. Moreover, yield curves indicate that long rates immediately after the meeting equaled those of early May. Thus, markets seem to have been well prepared for the June policy action, in contrast to their response in 1994. That earlier episode has been characterized as an "inflation scare" in which long-term rates jumped in reaction to an unanticipated series of rote increases. The policy surprise appeared to induce rising inflation expectations as investors feared that the FOMC had gotten behind the curve. Currently, long-term rates, though above their recent lows, are near their 2003 averages, suggesting that inflation expectations are well contained. Moreover, long-term inflation expectations implied by inflation-protected 10-year Treasury notes have been drifting down lately; consistent with independent evidence based on household survey data. …

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