US Interest Rate Forecasts:

Policy Maker vs. Market Forecasts

Last Wednesday, many listened to the Fed's statement as to when it expected to raise interest rates. The Fed funds rate has been at its current level since 2008; source.

Previously, concerns about a strong dollar had led many to speculate that the Fed would postpone a rate increase planned for an April-June time frame. The US dollar has appreciated almost 25% since May of last year versus the Euro. (1 Euro is worth $1.0817 today versus $1.3862 last May. Data source for historical exchange rates.) A strong dollar acts as monetary tightening for US exporters. It reduces earnings from goods and services sold abroad when translated back into dollars. (See afterthought at the end of this post.) 

Fed chairwoman Janet Yellen mentioned weaker forecasts of inflation and a downgrade to people's assessments of the long-run normal unemployment rate. Both of these imply postponement of rate increases.

There were dramatic reductions in median forecasts for official interest rates. 

FOMC members' median interest rate projections for 2015, 2016, and 2017 were reduced by 50-75 basis points from last December's projections (i.e. 3 months ago). 

However, futures markets are forecasting even lower rates than the Fed.

The FOMC's latest projections for the Fed's overnight borrowing rate are:

0.625% by 2015 year end, down from the previous forecast (last December) of 1.125%,

1.875% by 2016 year end,

3.125% by 2017 year end.

However, the futures markets' forecasts are:

0.5% by 2015 year end,

1.25% by 2016 year end,

1.85% by 2017 year end.

The Fed fund's rate is currently 0.12%; source.

(As excerpted from the Financial Times, March 20, 2015, page 24.)

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The above data is in terms of levels. We can also express them in terms of change in level. Then, the Fed's latest projected path of rate increases becomes: 

+0.5% change by 2015 year end,

+1.25% change by 2016 year end, 

+1.25% change by 2017 year end.

Meanwhile, the futures market thinks that the path of rate increases will be more like:

+0.38% change by 2015 year end,

+0.75% change  by 2016 year end,

+0.6% change by 2017 year end.

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Several observations are noteworthy. First, the market thinks that the Fed won't increase rates by as much as the Fed itself is projecting. This is obvious: In the last two data sets above, every line in the second data set is less than in the first data set. 

What is less obvious is that the market thinks that the third leg of tightening (+0.6%) will be weaker than the second leg (+0.75%). On the other hand, the FOMC is projecting identical tightenings (+1.25% and +1.25%). This suggests that the market sees economic weakness 2-3 years out whereas the FOMC doesn't ... Economic weakness would call for lower interest rates.

Furthermore, the market thinks that the "oomph" of the second leg (+0.75%) will be twice that of the first leg (+0.38%). In contrast, the FOMC's oomph for the second leg (+1.25%) is projected to be 2.5 times that of the first leg (+0.5%). This suggests that the market doesn't think the economy needs or can take that much tightening 1-2 years out.

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It will be interesting to keep track to see who ends up being right. 

It is important to remember that ultimately, it is the FOMC itself which sets the Fed funds rate, whereas the futures market can at best forecast it. The FOMC meets eight times a year: meeting calendars of the FOMC.

Previous expectations of a rate hike as early as June have now been replaced with September.

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Background

1. Question: Why is the Fed funds rate important? Answer.
2. Wikipedia article explaining the Fed funds rate.
3. FOMC = Federal Open Market Committee. About the FOMC.
4. Fed = US Federal Reserve System. Wikipedia article on the Fed.

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Why a strong dollar is bad for US corporate earnings

During a portion of last year (2014), when the US dollar appreciated by 5%, overseas earnings of US corporations fell by 7%. So, the multiplier effect exceeds one.

Furthermore, a good portion of S&P 500 company earnings come from overseas. Approximately 40% of S&P companies have overseas revenues, and 261 companies in the index have more than 15% of their revenues outside the US, according to data from S&P Dow Jones Indices. (Source: http://www.ft.com/, Jan. 19, 2015, "S&P 500 earnings face dollar headwind".)

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