On March 18 and 19, 2014, the Federal Reserve’s interest-rate-setting committee, the Federal Open Market Committee (FOMC), held its first meeting led by Janet Yellen, the new Federal Reserve chair. The outcome of this meeting in terms of the Federal Reserve’s plans for tapering and future increases in the federal funds rate provided more data points toward a base case that continues to increase in clarity.
This is an opportune moment to update you on this base case given the level of clarity, a level higher than we’ve seen since the global financial crisis.
The FOMC has eight scheduled meetings per year—two each quarter—one at the end of the first month of the quarter, and one in the middle of the third month of the quarter. During these two-day meetings, the FOMC has been providing increasingly longer-worded guidance on its thinking regarding any changes to the federal funds rate and its thinking regarding any changes to tapering its monthly purchases of bonds (Quantitative Easing 3, or QE3).
The FOMC began tapering after its final meeting in 2013 by reducing its bond purchases from $85 billion per month to $75 billion per month, a reduction of $10 billion per month. In its first meeting of 2014 (January 28-29), the FOMC continued its tapering, down to $65 billion per month. In its second meeting of 2014 (March 18-19), the FOMC again continued its tapering, announcing it would decrease bond purchase to $55 billion per month commencing April 1, 2014.
If the FOMC continues to decrease its purchases over the remaining six meetings in 2014, as is widely anticipated, then in the eighth meeting of 2014 (in mid-December), the FOMC will reduce its purchases from $5 billion per month to $0 (i.e., tapering will come to an end) and QE3 will be complete.
The risks to this base case are that the FOMC could either accelerate or decelerate this rate of change. Should these risks be realized, there may be noticeable reactions in the market, albeit temporary, lasting no more than three to six months and similar in nature to the May-June 2013 and September 2013 market responses.
Federal funds rate
The FOMC continues to communicate that it plans to keep short-term interest rates “low” for a long time. These short-term interest rates are driven by the federal funds rate, which is traditionally increased or decreased in increments of 0.25%.
The federal funds rate base case is that the FOMC will keep the rate unchanged until mid- to late-2015, at which point the FOMC will begin to increase the rate slowly. From a calendar perspective, mid-2015 could be as early as the late-April meeting, while late-2015 could be as late as the mid-December meeting. In terms of the FOMC increasing the rate slowly, slowly may mean a 0.25% increase every other FOMC meeting. A back-of-the envelope analysis could show the first rate increase happening in mid-June 2015 and subsequent rate increases every three months, which would put the federal funds rate at 1.00% in mid-December 2015, going to 2.00% in mid-December 2016, and continuing until ultimately leveling out somewhere around 4.00% sometime in late 2018 or early 2019.
The risks to this base case are that the FOMC could either accelerate or decelerate either the commencement of rate increases and/or the speed of the rate increase. At this point, we have little clarity on exact timing, while we do have reasonable clarity on the range of start dates.
Heading into this second FOMC meeting of 2014, one of the key news items in the financial media was how Ms. Yellen was going to improve the FOMC policy statement’s communication. When communication is the key question heading into a FOMC meeting (instead of federal funds rate changes or the execution of tapering), then there is more clarity in the market.
In 2013, the FOMC had first communicated that, when the unemployment rate reached 6.5%, it would begin to increase the federal funds rate (or at least this was how it was widely interpreted). Then this 6.5% unemployment rate was subsequently reported as the point at which the FOMC would begin to “think about” increasing the federal funds rate. Now the communication is that there is no longer a direct connection between the unemployment rate and when the FOMC will commence the rate increases—which we interpret as a standard investment mosaic process where everything the FOMC feels is relevant is pieced together to form its overall picture.
Discussions about the timing of when the FOMC will begin to increase the federal funds rate have been going on for years, but we now believe there is meaningful clarity. As we move through 2014, we expect QE3 to be tapered to $0 near year-end. If this occurs, we expect the FOMC would make its first rate increase sometime around mid-2015 to late 2015. And at this point, we expect subsequent rate increases to be slow.
Should you like to discuss these topics further, please contact us at Milliman Investment Consulting.