For both the real economy and for financial markets there are few variables as important as the Fed Funds rate. The pricing of stocks and bonds, the direction of the housing market and corporate hiring and investment plans are all ultimately affected, to a greater or lesser degree, by the decisions the Federal Open Market Committee (FOMC) makes on rates. It is therefore no surprise that there is a veritable industry of Fed watchers constantly second guessing FOMC members, trying to interpret their public utterances for clues as to the direction of policy and with their own reads on the incoming data. Nor is this industry confined to the United States. Given the dollar’s crucial role in global finance, one can find professional Fed watchers in every global financial center.
What is more surprising, and just a little depressing, is that they are usually wrong.
Over any reasonable time period, financial market expectations of the path of Fed Funds are usually incorrect.
Take as an example the upcoming meeting due to be held on the 20th March. As of the time of writing, market expectations (derived from futures prices and calculated by the CME’s Fed Watch tool) point to a 96% chance of rates being held at their current level of 5.25%-5.5%. In other words, investors are reasonably certain that the Federal Reserve will not be changing its policy rate next month. Given recent higher than expected consumer price inflation numbers, that seems likely to be correct.
But rewind back just two months to late December last year and the expectations looked rather different. On the 22nd of December 2023, just before traders headed off for their Christmas break, the pricing implied that the odds of Fed Funds being 5.25%-5.5% after the March 2024 meeting were just under 12% whilst the odds of a cut to 5-5.25% were more than 75%. Indeed, a rate of 4.75%-5% was seen as more likely than a rate of 5.25%-5.5%. Go back further and the miss becomes larger.
There is always a temptation to take the market-derived implied path of Fed policy as a good indicator of the future, or at least to weight it more highly than the views of economists pronouncing on what they think will happen. Afterall, the traders pricing futures have put their, or at least their clients, money where their mouths are.
There are plenty of reasons why the future-implied path tends to be wrong. Some if it relates to the market often hearing what it wants to hear rather than what was actually said. When the Fed signaled that it was done with hiking last Fall the market took that to mean that cuts would be following relatively quickly. More generally, close market watchers are keen to point out that the futures pricing is better seen as a snapshot of current sentiment than as something with predictive power for the future.
In general, when rates are low the market prices in hikes and when they are high, it prices in cuts. The belief in mean reversion tends to skew the numbers.
Still, futures traders can at least take solace from the fact that the policymakers actually setting the rates are not much better at predicting what path they will take. For more than a decade the Fed has been publishing the so-called dot plot where FOMC members give their estimates of where rates will be at the end of the current year, in two years’ time and in the longer run. Sadly, there is not much predictive power in these numbers either. As an example, at the end of 2021 the FOMC’s dot plot for the end of 2023 had Fed Funds as likely to be around 1.75%. The hiking cycle that actually followed went well beyond that.
Of course, the dot plot is a prediction not a promise. The Fed, as FOMC members are often keen to emphasize, makes its calls on the basis of the actual incoming data. Higher than expected inflation in 2022 and 2023 led to more hikes than the FOMC had envisaged as being necessary in late 2021.
Another reason to never take the FOMC’s dots at completely face value is that they, in and of themselves, can be thought of as a tool of policy. Expectations of future policy affect financial conditions in the here and now. An expectation that rates will rise in the future, for example, will affect the pricing of long-term loans made today. Sir Mervyn King, when he was Governor of the Bank of England, once referred to this as the Maradona theory of interest rates. As King explained, Maradona – one of the all-time great football (or soccer, if I must) players – scored for Argentina against England in a 1986 World Cup match with an astonishing goal:
“Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on”.
Monetary policy, as King noted, can work in a similar way. Markets react to what they expect a central bank to do as much as what it actually does. Although central banks need to be careful when they consciously try to manage expectations, Maradona after all was a player of legendary talent and most players trying to run 60 yards through five defenders in a straight line would simply get tackled.
If the market implied path of rates is not a helpful guide to the future and the central bank’s own projections are not much better, where can one turn to? One helpful source in recent years has been the surveys of economists carried out jointly by the FT-Booth US Macroeconomists Survey. This at least has the advantage that its members have no vested interests, other than their own credibility, at stake when they make their forecasts. And over the last two years it has generally had more predictive power than either the futures pricing or the dot plot. At the last survey, in December, the panel expected no cuts before July 2024 whilst the market expected two cuts by the middle of the year.
As financial marketers are obliged to point out; past performance is no guarantee of future success. But there are reasons to give more weight to the views of outside experts than either traders or policymakers when it comes to the path of interest rates. That is a subject to which this column will soon be returning.
