Parsing Gradually

With the vast majority of economists and primary dealers expecting the Federal Reserve to lift rates next month, the subject of discussion has shifted toward the pace of the hikes and the peak or terminal rate.  

The Federal Reserve has used various word cues to help guide market expectations.  There was, for example, going to be a "considerable period" between the end of the asset purchase program and the first increase in rates.   Fed officials, even those who have argued against a hike this year, have sought to reassure investors that the pace of increase will be "gradual."  Indeed, the Fed's leadership has argued that by raising rates soon, against the expressed recommendation of the IMF, it will increase the opportunity to move at a "gradual" pace. 

So what does "gradual" mean for the Federal Reserve?   It is meant to distinguish how it sees its task from recent tightening cycles.  In 1994, for example, the Federal Reserve hiked the Fed funds target by 300 bp in a little more than a year.  In the 2004 tightening cycle, the Fed funds target was raised by 200 bp a year for two years.  

Remember the latest tightening cycle by the Greenspan Fed was a 25 bp rate hike at nearly every meeting.  This is not what the Fed now means by gradual.    In September, the Fed's dot-plot implies a hike at every other meeting.  This is once a quarter and 100 bp in 2016. 

The market is less sanguine.  The December 2016 Fed funds futures contact implies an average effective Fed funds rate of 83 bp at the end of next year.  The implied yield has not been above 100 bp since mid-August.  It finished last year with an implied yield of 154 bp.  

There are three ways in which this tightening cycle will differ from past cycles.  First, there is a target range for Fed funds as opposed to a fixed point target.  The Fed funds futures settle at the average effective Fed funds rate over the course of the month.  It is not clear exactly where in the range the Fed funds will gravitate.

While a neutral assumption is the middle of the range, the second way this cycle differs from past cycles complicates the assessment.  This will be the first tightening cycle in which the Fed will pay interest on excess reserves.  Fed officials have emphasized that interest on excess reserves (IOER) will be an important tool in controlling liquidity after lift-off.  

To maximize the effectiveness of this tool, a wide gap between the Fed funds rate (what the market pays for excess reserves) and IOER may be preferable.  This would also underscore the Fed's commit to gradual tightening process.  This suggests an incentive for the Fed to provide sufficient liquidity to keep the effect Fed funds rate below the midpoint of the range.  

The third way that this cycle differs from past cycles is the role of the Fed's balance sheet.  For many market participants, the act of expanding the balance sheet was the easing of QE.  Fed officials argued that it was not the buying buy but the holding of securities that was the key transmission channel.   

There is an estimated $220 bln of Treasury bond on the Fed's balance sheet that are set to mature next year.  Fed officials have indicated that sometime after lift-off it would consider not re-cycling the maturing proceeds.   This tool is another dimension of monetary policy that can supplement and compliment that increase in rates.  Its use can also ensure a gradual rate hiking cycle.  

During the last cycle, Fed funds peaked at 5.25%  The cycle before that Fed funds peaked at 6.5%.  There is a strong consensus that in this cycle Fed funds peak considerably lower.  In the past, the real Fed funds rate has dipped below zero before the economic cycle turns.  This time, many are looking for the Fed funds rate to peak around the Fed inflation target, or perhaps a little into positive territory in real terms. 

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