As Macro-driven investors we spend a lot of time studying monetary policy and its impact on the economy. Now that the Federal Reserve has tightened rates for the first time since 2006 it may be worth looking at what happened to short-term interest rates the last couple of times they embarked on a tightening campaign.
I want us to take a look at the most recent FED cycles to see if we can glean any insight from the past couple of decades on how high rates might go in this tightening cycle.
Starting in the late 1980’s, we had a series of rate cuts that eventually brought the FED funds rate down to 3% by 1992.
(Chart courtesy of Bloomberg)
The rate then stayed there until February 1994. The FED Funds rate is the yellow line in the chart above. The white line is nominal GDP growth (GDP growth including inflation). When the FED started tightening in early 1994, nominal GDP was running right around a 5% annual rate. A year later, on February 1, 1995, the FED was done tightening with the Fed Funds rate having reached 6%. At the time, this was roughly in line with nominal GDP growth.
The next significant policy change came in January 2001, when the FED embarked on a new round of easing in response to the post-bubble recession. By the summer of 2003, the FED funds rate had fallen to 1%, where it stayed for about a year until a new tightening campaign began.
As can be seen on the chart, a huge gap between FED Funds (at 1%), and nominal GDP (above 6%) had once again opened up in 2003, and the tightening campaign once again closed that gap.
By the summer of 2006, the Funds rate hit 5.25% and stayed there until September 2007, when the FED started to see downside risks to growth from a slowing housing market. This was, as we now know, the beginning of the Global Financial Crisis, which ultimately required a whole slew of emergency measures to contain it. One of these measures was maintain a FED Funds rate of zero to .25%, which having been initiated on December 16 2008, was the official rate until December 16 2015, exactly seven years later.
Once again, there exists a significant gap between FED Funds and nominal GDP growth. The question now is, where will this tightening cycle end?
If recent history is any guide, we should at least consider the possibility that the terminal rate will approach the nominal GDP growth rate, which currently is running around 3.1%.
Further guidance can be had by looking at what the Federal Open Market Committee (the committee that sets the Fed Funds rate) members themselves are saying about the longer-term outlook for rates. Four times per year, FOMC members provide forecasts for rates which are summarized in a chart known as the “The FED Dot Plot”. On December 16 2015 we received the latest update, which can be seen in the chart below.
(Chart courtesy of Bloomberg)
The Blue line represents the median of the FOMC member’s own forecasts and the Red line is what the market is expecting – OIS stands for Overnight Index Swaps and is a way to trade the future FED Funds rate.
It is interesting to note that the market (the Red line) has a far more benign outlook for rate hikes than either history or the FED’s own predictions (the Blue line)would suggest. Not only does the market think that the FED will hike at a much slower pace than they themselves currently predict, but the terminal rate looks to be close to 2%. The longer term median rate according to the FOMC is at 3.5% – not that far from current nominal GDP growth and therefore consistent with recent history of FED tightening campaigns.
It remains to be seen whether the market or the FED will turn out to be “right” about the path of interest rates, but what is clear is that market participants aren’t particularly worried about the recent change in FED policy.
Jan Erik Warneryd is the Senior Portfolio Analyst at Hillswick Asset Management, a participant in the ETF Strategist Channel.