Are the Fed’s interest rate projections credible?

At the FOMC meeting on September 19 and 20, members charted the central bank’s so-called dot plot of expected rates for the years out to 2020, involving one interest rate hike in 2017, three in 2018, two in 2019 and only one in 2020, leading to an end figure of 2.875% vs. 1.125% currently. These figures published by the Fed are generally extreme, as the US central bank endeavors to influence investors’ expectations to suit its own narrative.

The extent of the bank’s excessive stance is clear when we look at recent projections for 2016 and 2017. In December 2015, the dot plot expected 1.375% at the end of 2016, but the figure actually came out at only 0.625%. In December 2015, 2.375% was expected for 2017 but by June 2016 the projection stood at 1.375%. It is currently 1.125% and will come to 1.375% by the end of the year if we take the Fed at its word.

The interesting point about these forecasts as well as figures to be announced in December is that they will be the last stats from the current committee before a likely radical shake-up for the board of the Federal Reserve in Washington. So will the new-look board be bound by forecasts from current members ? Certainly not.

Looking into the Federal Reserve board’s make-up in greater detail, it consists of seven members including Chair Janet Yellen. Three seats currently lie vacant: two because US Congress did not approve Barack Obama’s choices (including winner of the Nobel Prize for Economic Sciences Peter Diamond) and another since the recent departure of Daniel Tarullo on April 5, 2017. The remaining members will be there for many more years to come. Janet Yellen’s term will end on February 3, 2018 and she will remain a member of the board until January 31, 2024. Vice Chairman Stan Fischer’s term will run until June 12, 2018. Jerome Powell is there until January 31, 2028 and Lael Brainard’s term ends on January 31, 2026.

Current members still remain in the majority, so we can conjecture that the future policy implemented would be consistent with the decisions taken by the current board particularly during its last meeting (I am making a tried and tested assumption in the US that the MPC that also includes presidents from regional Federal Reserves follow the Chair’s choices even if one or two challenge them).

But the situation is set to get a bit more complicated as Stan Fischer announced he would leave on October 13, so he will not be sitting around the meeting table at the 31 October/November 1 meeting.

Donald Trump will have to appoint four out of seven members and he will potentially enjoy a central bank whose policy will be defined by the members he himself has chosen. The four will include the new Federal Reserve Chair. I don’t think it will be Janet Yellen again, and despite an amiable dinner with the president’s daughter, Ivanka Trump’s influence in choosing the Fed chair is probably somewhat limited. The new line-up for the board gives the US president a clear opportunity to brand the Fed with his own iron, which he is having trouble doing with his own Republican majority in Congress.

It is now likely that the dot plot will be lower than the Fed currently projects, and this is what the market is expecting. Trump’s choice of candidates for his four new governors (one is already nominated, private banker Randal Quarles, and is awaiting confirmation from Congress) will be heavily influenced by his intention to keep interest rates low, an aim he often mentioned as a way to boost to low-cost financing. So the dot plot will remain low and we cannot expect an increase across the entire interest rate profile in the months ahead. This is why the euro/dollar rate has hardly shifted, despite the Fed’s projections of higher rates.
However, one key point remains the four appointments and their approval by Congress. Donald Trump seems to be getting along better with the Democrats than his own party on certain key issues (debt ceiling, situation for the Dreamers), so will he be able to rely on his own party to endorse his choices?

If Trump’s intention to keep interest rates low is the key criterion in his choices for the next Chair and governors, then it is unlikely that the Fed will implement a monetary policy rule to set Fed Funds, but rather continue to make decisions based on its judgment, contrary to the wishes of some Republicans in Congress. In a calculation I based on inflation and unemployment and using the parameters estimated on the basis of a reference period of 1990-2007, the Fed Funds rate would stand at 4.3% in August 2017, well above the central bank’s current 1.125% key rate.

This all points to continued low interest rates for quite some time to come, even in the US.

This is my weekly column for Forbes. You can read it in French here

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