Regardless of when the Fed decides to act, the more important question has to do with the velocity of the ascent and the cruising altitude that interest rates reach after liftoff . . . or should I say takeoff. In other words, more important than when the Fed starts is where it stops!
During the last tightening cycle, which ended in 2006, the federal funds rate went from 1% to 5.25% in just two years. The current tightening cycle should prove very different, as we discussed in our 2015 global economic and investment outlook. Indeed, we shouldn’t expect a vertical liftoff but rather a much more gradual ascent (perhaps as low as 1% in the first two years), as well as a much lower cruising altitude (a terminal rate of 3% or lower) than some are anticipating, including the Fed. Should our view prove correct, U.S. long-term interest rates and bond prices may not react as negatively as some investors fear.
As part of this gradual tightening, an extended pause, perhaps at 1%, makes a lot of sense. For one, it would mark a removal of some of the policies exercised by the “exigent circumstances” during the financial crisis. It would also give the Fed the chance to reassess how some of the new instruments it has at its disposal are operating and how economic conditions are responding after the historic move off the zero floor. Most important, it will ensure that the federal funds rate remains well below the level of inflation at least through 2017. The global economy is strong enough to warrant takeoff but may not be strong enough to take on a positive real federal funds rate just yet, given such divergent monetary policies.
So, whether rates are raised at this meeting or later this year, we should expect a much lower cruising altitude for the federal funds rate than in previous tightening cycles, achieved with more measured and staggered rate increases than in previous flights.
Although I may qualify this as a “dovish tightening,” I will ultimately view a decision to raise rates as both prudent and welcome following six years stuck at the zero bound. And it will again be a testament to the resiliency of the U.S. economy and its people.
This article was written by Joseph H. Davis, Ph.D., a principal, Vanguard’s global chief economist, and global head of Vanguard Investment Strategy Group.