Where are Interest Rates Headed?

 

The Federal Reserve met last week. The Fed’s statement at the end of their two day meeting and Chairwoman Janet Yellen’s press conference provides insights regarding the future of interest rates, inflation and the economy.

 The Fed continues to feel that the economy is expanding, but at a moderate pace. The Federal Reserve has a legal dual mandate to strive towards “full employment” and to hold long term inflation at around 2%. The Fed feels inflation is currently below 2% and longer term inflation expectations are “stable.”

 The Fed reaffirmed its current “highly accommodative stance” of very low interest rate levels. Short term interest rates (for maturities under a year) are near zero. They “anticipate” these very low interest rates “likely will be appropriate… for a considerable time (emphasis added) after the (bond) asset purchase program ends…” Their current bond asset purchase program, which is a method the Fed has used to reduce long term interest rates, is expected to conclude at their next meeting, in October, 2014.

 When will short term interest rates begin to rise? What does the Fed mean when they say rates will stay low for a considerable time? The Fed has not provided specific answers. Chairwoman Yellen said this is based on how the economy performs.

 The Fed has provided guidance of their interest rate expectations. Past guidance for short term rates (defined as “the fed funds rate”) were for 1.25% in late 2015 and 2.5% in late 2016. The current projections are between 1.25%-1.50% in late 2015 and 2.75-3.0% in late 2016. While these are helpful, it is important to note that in reviewing past guidance that the Fed has provided, their own predictions have often been inaccurate.

 As current fed funds rates are near zero now, this implies an increase in short term interest rates of approximately 1.5% over the next 15 months and an additional 1.25% – 2% increase in the following year (2016). Compared to where interest rates are today, the Fed is projecting a 3% increase in short term interest rates over the next 24-30 months. This is a significant increase from today. The Fed’s projections for interest rates by the end of 2016 are more aggressive now than they projected in June, 2014.

While the Fed has not stated when short term rates will begin to rise, based on their internal projections, rates are likely to begin rising sometime in the first or second quarter of 2015. As stated above, the Fed said interest rates will remain low for a considerable time. However, based on their internal projections, the Fed’s definition of “considerable time” appears to be much shorter than what most people think that would mean. The Fed appears to be thinking in terms of months, while most people would think considerable time means much longer than that. This is an important distinction to understand.

The Fed expects economic growth to continue to expand, but at a reduced level than they projected in the past. They now project the economy to grow below 3% annually over the next three years. This compares with a 3.4% growth rate during the 1990s.

 

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