Investment Research Beyond Lift-Off Scenarios for the Federal Funds Rate Ronald Temple, CFA, Managing Director, Portfolio Manager/Analyst David Alcaly, Research Analyst With the US Federal Reserve poised to begin raising interest rates for the first time in nearly a decade, the timing of lift-off is the subject of intense scrutiny. We think the Fed should wait until 6 to allow for clearer signs of labor market tightening and stronger inflation before acting. However, we expect that the first rate hike is likely to happen this year and that the subsequent trajectory of rate hikes will be much more important than the timing of the first one. In this paper, we examine three scenarios for rate increases and discuss their implications for markets.
Introduction It has been almost seven years since the US Federal Reserve s (the Fed) Federal Open Market Committee (FOMC) cut the federal funds rate target range to %.5%. Now, investor expectations for lift-off, or the date when the FOMC begins raising rates, range from as early as September 5 to as late as March 6. While the timing of liftoff is interesting, we believe that the subsequent pace of rate increases and the level rates reach are even more important topics. We continue to believe that the FOMC should wait until 6 to begin raising rates, based on our assessment that a substantial excess supply of labor remains. Our latest estimate is that the United States needs to create between. and 4.8 million jobs to absorb this slack, a process that could take anywhere from to 4 months, assuming the United States can create 5, to 75, jobs per month. Nevertheless, a number of recent speeches by voting FOMC members indicate that lift-off may well occur in 5. We think it is important to point out that raising rates by 5 basis points (bps) or even 5 bps is not likely to substantially affect the growth rate of the US economy or the pace of labor market healing. In fact, this may be the belief of the many FOMC members who want to get off the zero lower bound and begin the process of normalizing monetary policy. In this paper, we examine three scenarios for lift-off, the pace of rate increases, and how high rates might go in this tightening cycle. Clearly there are infinite potential scenarios, but we have identified probable scenarios that allow us to assess investment implications.¹ Similarly, for the sake of succinctness, we have opted to set aside the muchdebated longer-term question of whether future potential economic growth has been reduced, as proponents of the secular stagnation theory believe, as well as the topic of potential future reductions to the size of the Fed s balance sheet. Scenarios Our scenarios present the range of what we consider to be the most likely paths for the federal funds rate target range. As such, we focused on when the FOMC may begin to increase rates, a general pace for subsequent rate increases, and the target range two years from now. The box titled Scenario Analysis for the Federal Funds Rate (page 4) outlines these scenarios and their likelihood, as well as the rationale for and implications of each, but in brief: Base case: lift-off takes place at the December 5 FOMC meeting and the federal funds rate target range reaches a % upper bound by mid-7. Hawkish case: lift-off takes place at the September 5 FOMC meeting and the federal funds rate target range reaches a % upper bound by mid-7. Dovish case: lift-off takes place at the March 6 FOMC meeting and the federal funds rate target range reaches a.5% upper bound by mid-7. These scenarios all imply that rates will remain extraordinarily low by historical standards, as shown in Exhibit. It is important to note that there is no parallel in US history for the current monetary policy. Hence, we do not find it instructive to look back to previous tightening cycles or inflationary episodes. We note our scenarios are to the dovish side of FOMC median projections and roughly in line with futures markets, as can be seen in Exhibit. While we recognize the directional importance of the FOMC s Summary of Economic Projections (SEP), we do not believe that FOMC forecasts are terribly predictive of the future course of rates because they are based on each FOMC member s assumption that an ideal policy path is pursued and that the economy responds as expected. This framework is, in our view, unrealistic both because ) individual views on the policy path and the economy differ; and ) because the framework to some degree contradicts the data dependence of monetary policy. Exhibit The Effective Federal Funds Rate Is Likely to Remain Extremely Low by Historical Standards (%) 4 8 Exhibit Our Federal Funds Rate Scenarios Are Roughly in Line with the Market (%) 6 96 965 97 975 98 985 99 995 5 5 Jun 5 Nominal Effective Fed Funds Rate Core PCE (YOY Change) As of April 5 Source: Federal Reserve Board, Bureau of Economic Analysis Dec 5 Jun 6 Dec 6 Jun 7 Hawkish Case Base Case Dovish Case Median FOMC Projection from Latest Assessment Federal Funds Futures Implied Effective Federal Funds Rate Dec 7 As of 7 June 5 The median FOMC projection for the Fed Funds Rate in the longer term is.75%. Estimated or forecasted data are not a promise or guarantee of future results and are subject to change. Source: Bloomberg, Federal Reserve Board, Lazard
One important implication of our relatively dovish scenarios is that they do not leave a lot of dry powder in the form of the ability to use interest rates as a policy tool for the FOMC in the next business cycle. This lack of tools increases the likelihood that the FOMC will need to resort to quantitative easing (QE) and other unconventional measures and that the Fed s balance sheet may not return to its precrisis size, implications that the FOMC no doubt might wish to avoid. Progress on the Dual Mandate As the FOMC has repeatedly reminded markets, its decisions ultimately are dependent on incoming data. However, as implied by our scenarios, we believe that considerable ambiguity remains on how close the FOMC is to achieving its dual objectives of maximum employment and % inflation, and over how the economy will react to monetary policy tightening. The labor market has made significant progress since the crisis, with momentum accelerating in 4. Over the past year, the United States added. million nonfarm payroll jobs with an average of 7, jobs per month over the past three months. Similarly, the unemployment rate dropped from 6.6% at the beginning of 4 to 5.5% in May 5, nearing the central tendency of the FOMC forecasts for the longer-run unemployment rate of 5.% 5.% from the June SEP. However, as we discussed in our Investment Research paper,² Estimating US Labor Market Slack, the unemployment rate only covers unemployed individuals who have looked for work in the past four weeks and are thus considered part of the labor force. Other metrics that capture levels of under-participation in the labor force or underemployment remain further from pre-crisis levels, including our preferred indicator, the employment-population ratio (E/P ratio), which measures the number of employed against the total employable population. Updating our calculations from December 4, which adjust the E/P ratio for the aging of the workforce and increased disability claims, we estimate that as of May 5 a jobs gap of. 4.8 million jobs remained, with a gap of.5 million jobs as our base case (Exhibit ). Even with optimistic assumptions about the pace of jobs growth and the number of these jobs that ultimately are filled, this gap could take roughly to 4 months to close. Adding to ambiguity about the health of the labor market is persistently weak wage growth. The two most commonly cited indicators, average hourly earnings (AHE) and the employment cost index (ECI), have both shown year-on-year rates of change around % for much of the past two years, well below the level required to keep up with the FOMC s inflation target plus the long-run rate of productivity growth. However, both measures have shown mild improvement recently. In May, the year-on-year change in AHE, which captures not just changes in wages but also changes in the overall composition of high- and low-wage jobs, rose to.%. In the first quarter of 5, the year-on-year change in ECI for wages and salaries, which corrects for changes in the composition of jobs, jumped to.6%, although when incentive-paid occupations are excluded it was a more pedestrian.% (Exhibit 4). For her part, FOMC Chair Janet Yellen has cited evidence that wages have a stronger historical relationship with factors other than labor market conditions, like productivity growth, and said that for this reason stronger wage growth is not a prerequisite for lift- Exhibit Estimated Labor Market Slack Employment-to-Population Ratio (%) 66 6 6 57 54 949 96 Sizing the Jobs Gap 976 989 6.4% Dec 6.M jobs 59.4% May 5 5 Peak E/P Ratio (%) Dec 6 6.4 Implied Employment at Peak E/P Ratio (Millions) 58.9 Jobs Gap (Millions) May 5. Explained by Aging (Millions) May 5 4. Disabilities (Millions) Apr 5. Unexplained Jobs Gap (Millions) May 5 4.8 Unexplained Jobs Gap if True Peak E/P Ratio Is Lower than Dec 6 Base Scenario (Millions) (6.9% E/P Ratio) Low Scenario (Millions) (6.4% E/P Ratio) As of May 5 Estimated or forecasted data are not a promise or guarantee of future results and are subject to change. Source: Bureau of Labor Statistics, Lazard Exhibit 4 Wage Growth Improving? YOY Change (%) 4 7 9 Average Hourly Earnings (Total Private Industries) Employment Cost Index for Wages and Salaries (Civilian Workers) Employment Cost Index for Wages and Salaries (Civilian Workers, ex Incentive-Paid Occupations) Average hourly earnings as of May 5. Employment cost index is disaggregated quarterly data as of March 5. Source: Bureau of Labor Statistics, Lazard.5. 5
4 Scenario Analysis for the Federal Funds Rate³ Trajectory FOMC Rationale Implied Economic Conditions Investment Implications Base Case 5% probability Hawkish Case 5% probability Dovish Case 5% probability Lift-off at the 6 December 5 FOMC meeting, with the federal funds rate target range set to.5%.5%. The FOMC continues to emphasize that future increases will be data dependent to avoid undermining the economic recovery. Subsequent rate increases follow a cautious path: 5 bps at every other FOMC meeting. By mid-7, the federal funds rate target range reaches.75%.%. The developed world remains saddled with extraordinarily high levels of debt. Weak real GDP growth and low inflation rates slow the deleveraging process, forcing the FOMC to remain accommodative. Lift-off reminds markets that % is not the normal federal funds target rate. The gradual pace of rate increases keeps real rates at or slightly below % in recognition that deleveraging is not over. The FOMC recognizes labor market slack but believes it will diminish. Similarly, the FOMC is concerned by weak inflation but reasonably confident that it will eventually accelerate. The FOMC also wants to protect against future blame for a potential bubble in fixed income markets. Raising the target rate by 5 bps and then following a slow path shows it is aware of risks to financial stability. Economic growth remains uninspiring, with real GDP growing about % per annum. Labor market slack slowly diminishes, while wage growth remains weak well into the hiking cycle. The inflation rate slowly trends toward %, remaining subdued. Yield curves flatten as investors realize that the effective federal funds rate is likely to be around % deep into the recovery. Good for income-producing alternatives. FX volatility remains relatively low, as the FOMC moves at roughly the pace anticipated by markets. A permanently lower discount rate could lead to higher valuations, but the implied weakness of the recovery could lead to lower revenue growth expectations. These factors could create a barbell, with growth stocks achieving even higher valuations and high-dividend-yield stocks also rising in value. More highly leveraged companies could underperform in recognition that the free money era is over, though the impact would be limited by the still-low level of rates. Lift-off at the 7 September 5 FOMC meeting, with the federal funds rate target range set to.5%.5%. Subsequent rate increases follow a cautious path at first before accelerating later: 5 bps at every other FOMC meeting through mid-6 and then each FOMC meeting through mid-7. By mid-7, the federal funds rate target range reaches.75%.%. The FOMC believes labor market slack is both overestimated and diminishing, and recognizes lags in monetary policy. It also believes weak inflation is due to transitory factors and that weak wage growth is more driven by factors outside its control, like productivity growth. The FOMC is eager to get off the zero lower bound and, having guided investors to expect lift-off in 5, wants to meet expectations to avoid destabilizing global markets. It sees potential benefits in: Getting past a milestone that has created high levels of anxiety; Signaling its view that the US economy is healthy; and Reminding markets that rates won t be zero forever. The actual changes in rates are still relatively small and monetary policy will still be accommodative for some time, giving the FOMC confidence that it won t derail the recovery and that it will have tools to combat inflation. Economic recovery resumes the pace observed in the second half of 4, while concerns over weaker growth seen in the first quarter of 5 and the impacts of a stronger dollar recede. The labor market shows clearer signs of tightening and stronger wage growth gradually materializes. Confidence increases that inflation is returning to % and has been weighed down by the transitory impacts of low energy prices and a strong dollar. Meaningful downside risk in long-duration fixed income instruments. FX volatility could increase substantially as investors adjust their expectations to a more hawkish trajectory. Equity markets could face downside risk as investors question the appropriate discount rate for future cash flows. This could be somewhat balanced by a stronger economic outlook, especially if momentum builds in consumption and housing. Active managers could benefit as winners from the period of exceptionally low rates become the relative losers in an environment of increasing rates. Lift-off at the 6 March 6 FOMC meeting, with the federal funds rate target range set to.5%.5%. Subsequent rate increases follow a very slow and cautious path: 5 bps at every to 4 FOMC meetings, with elevated chances of extended pauses. By mid-7, the federal funds rate target range reaches.%.5%. Extraordinarily high levels of debt and slow deleveraging are weighing on economic activity and the FOMC wants to be very cautious about rate hikes to ensure that the economy can handle the higher debt service burden. The FOMC shares our point of view on labor market slack, especially given disappointing wage growth. Some members place added emphasis on the need to draw people back into the labor force. Low inflation rates, particularly in a globally weak environment, are a significant concern and the chances of overheating are slim. The FOMC wants to be sure that this weakness is transitory and prefers seeing the whites of inflation s eyes over continuing to miss its target. Economic growth decelerates, though not to the point of a recession. Similarly, the net absorption of excess labor slows and wage growth remains weak. Inflation remains stubbornly low, forcing the FOMC to begin contemplating other extraordinary measures to achieve its target. There is sustained weakness in the global economy, as well as elevated deflationary pressures. Increased urgency in the search for yield drives investors to longer-duration, riskier fixed income instruments. Good for income-generating equities and income alternatives. FX volatility could decrease in G currencies as monetary policy is not as divergent as anticipated. Emerging markets currencies could rally as a Taper Tantrum Part will not be realized. Equity markets could benefit as investors reassess future discount rates and realize that stocks trading at a forward P/E ratio of 6 8 times, often with dividend yields well above sovereign debt yields, are a relative bargain.
5 Exhibit 5 Inflation Remains Subdued YOY Change (%) Jan Nov Core PCE Sep 6 As of April 5 Source: Bureau of Economic Analysis Jul 9 May Mar 5 off, although weaker wage growth would make her uncomfortable. Nonetheless, a sustained acceleration in wage growth would provide significant confidence that the jobs gap is closing and would contribute to a stronger recovery via rising income and higher inflation. Similarly, the FOMC s preferred measure of inflation, the year-onyear change in the personal consumption expenditures price index less energy and food (core PCE) has been below the FOMC s target of % for 76 of the last 79 months, and stood at.% in April 5 (Exhibit 5). In recent comments, the FOMC has attributed current weakness to the transitory effects of low oil prices and a strong dollar and pointed to relatively consistent survey-based measures of inflation expectations to support its belief that inflation will return to its target in the medium term. It has however, hedged this view somewhat by asserting that while it is willing to raise rates at the current pace of inflation, it needs to be reasonably confident that the inflation rate is heading to %. A weak global environment may put pressure on US inflation for some time, and we believe the FOMC will at a minimum want to ensure that: inflation does not deteriorate further, various measures of expectations remain steady, and then inflation actually begins to grow more strongly as the labor market presumably tightens. Conclusion As we near the FOMC s first rate hike in almost a decade, attention is understandably focused on its timing. While we believe the FOMC should wait until 6 to allow for clearer signs of labor market tightening and stronger inflation, we also recognize that lift-off is likely to happen this year and that the subsequent trajectory of rate hikes is likely to have much greater importance for the economy and investors than the first 5 or 5 bps. In order to consider the differing impacts of probable rate trajectories, we have outlined three scenarios that we believe bound the most likely possibilities, given the ambiguity over how close the economy currently is to the FOMC s dual mandate and over how it will react to rate hikes. In all three scenarios, we expect the US economy to continue growing at a relatively moderate pace with varying degrees of labor market improvement. We also see two of the three scenarios as relatively benign for investors in equities and fixed income. It is only in our hawkish scenario that we see more volatility arising as the market is currently pricing a path that is meaningfully different from this case. Regardless of which scenario ultimately unfolds, we continue to focus our bottom-up research on identifying securities that we expect to outperform based on their company-specific drivers. We continue to believe that the best investments are in shares of companies that have strong balance sheets, robust organic cash flow growth, and the operational flexibility that arises from these characteristics, thus allowing a company to navigate the twists and turns of monetary policy. Notes We note that our three scenarios could change as the economy and markets react to FOMC actions. In particular, timing and communication early in the policy normalization cycle will be critical for the FOMC, due to the potential for markets to overreact. To draw an extreme example of overreaction, if the FOMC raises rates at two consecutive meetings and investors assume that tightening will continue at every meeting for an extended period of time, it could lead to a sharp steepening of the yield curve, a spike in the value of the US dollar and a sell-off in equities that undermines the very recovery that was the catalyst for the FOMC to act. 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