S.F. Fed: Investors See Rate Hike Inching Closer

Although Federal Reserve Board policymakers have not changed their statement regarding when they will raise the Fed funds target rate, investors have moved up their expectations of when the Fed will act, targeting the spring of 2015, according to an economic letter by Federal Reserve Bank of San Francisco senior economist Jens Christensen.

"U.S. Treasury yields and other interest rates increased in the months leading up to the Federal Reserve's December 2013 decision to cut back its large-scale bond purchases," Christensen writes. "This increase in rates probably at least partly reflected changes in what bond investors expected regarding future monetary policy. Recent research on this episode tentatively suggests that investors moved earlier the date when they believed the Fed would exit its zero interest rate policy, even though Fed policymakers made few changes in their projections of appropriate monetary policy."

The FOMC in December 2008 cut the target rate to zero to 0.25%, where it has been since. When the economy remained sluggish, the FOMC used "unconventional measures," including large-scale asset purchases and forward guidance on how long it plans to keep its target rate near zero. "The effect of this forward guidance depends on how financial market participants interpret FOMC communications, in particular when they expect the Fed to exit from its near-zero rate policy," Christensen noted.

Christensen's "research suggests that bond investor expectations for the date of exit have moved forward notably in recent months, probably because they anticipated the FOMC's decision at its December 2013 meeting to cut back large-scale asset purchases. This research suggests that market participants expect the FOMC to start raising rates in the spring of 2015, but the exact timing is highly uncertain."

FOMC participants predict in the quarterly summary of economic projections, when they believe the rates will rise. There were minor changes in the FOMC projections from September to December. "The relatively stable FOMC projections stand in contrast to changes in the U.S. Treasury bond market over the same period," Christensen said. The Treasury yield curve, shows "medium- and longer-term Treasury yields increased notably" from September to December. "…much of this increase in longer-term Treasuries reflected an increase in the term premium."

In the analysis, on Dec. 23, 2013, "The exit date distribution is heavily skewed so that very late exit times are significantly probable. Still, the median exit date is in March 2015." Comparing that to other periods where major FOMC announcements occurred, "The estimated median exit time from the zero-bound state moved notably later in the weeks after each announcement, except when the FOMC extended its forward guidance in January 2012."

So, Christensen said, "This suggests that unconventional policies derive part of their effect by sending signals that bond market participants interpret to mean that the federal funds rate will remain at its zero bound longer than previously expected."

When market participants expected the Fed to taper its asset purchases, between the September and December meetings last year, the market also expected the first federal funds rate increase to move up, and that expectation remained "even though the FOMC's projections of the appropriate future fed funds rate hardly changed from September to December."

On "December 27, 2013, the median exit time for the market was estimated at one year and three months, which implies that the odds of keeping the near-zero interest rate policy past March 2015 are identical to the odds of exiting before that date."