For the last several months, talk of tapering has dominated the Fed debate. Although there remains some uncertainty around the details—such as how large the initial step might be—most observers now expect the Federal Reserve to begin slowing the pace of quantitative easing (QE) at the September 17-18 meeting. Attention is now turning to another major issue on next month’s agenda: the publication of Fed officials’ forecasts for the funds rate in 2016. The Fed rolls forward the Summary of Economic Projections (SEP) by one year each September. This year the updated forecasts will take on added importance because the first rate hike is expected in 2015 and the economy should be near full employment by 2016. They will therefore reveal important new information about the Fed’s reaction function by showing the speed of future rate hikes for the first time.

Past Fed communication offers a few clues about what this rate path might look like. In particular, Chairman Bernanke fielded a few questions on this topic when the FOMC introduced the Evans Rule last December. He emphasized two points: (1) that the speed of rate hikes would be gradual, and (2) that Vice Chair Yellen’s “optimal control”1 simulations presented in a speech last November were along the lines of what they had in mind. Here are the key quotes from the press conference transcripts:

“My anticipation is that the removal of accommodation after the takeoff point, whenever that occurs, would be relatively gradual. I don’t think we’re looking at a rapid increase … the path that we’re basing these numbers on … does not necessarily assume a rapid increase after [the unemployment rate reaches 6.5%] … assuming that inflation remains well controlled, which I fully anticipate, I think that the rate of increase in rates would be moderate.”

“So, the kind of optimal policy path that Vice Chairman Yellen showed is indicative of the kinds of analysis we’ve done. I mean, we’ve run it for a variety of different scenarios, different assumptions about models, and so on, but the general character of that interest rate path, i.e., that it stays low until unemployment is in the vicinity of 6½ or a little lower, and then rises relatively slowly, which goes back to the question that was asked earlier, that it doesn’t involve a rapid removal of accommodation after that point is reached. That is consistent with that kind of analysis, and that’s the type of analysis that was not the only thing we looked at but was informative in our discussion.”

So what might this look like in practice? In her November 13 speech, Vice Chair Yellen’s optimal control simulation showed an average increase in the funds rate of approximately 25 basis points (bps) per quarter, or 100bps per year. Interestingly, this is roughly in line with the pace of rate hikes shown in the June SEP for late 2015. If we remove the four FOMC participants that are forecasting funds rate increases before 2015 (because they are very far from the committee consensus), then the average projected funds rate for the end of 2015 equals 76bps (Exhibit 1). If at the time of the June FOMC meeting most participants expected the first rate hike in “mid 2015,” then these forecasts would also imply a pace of increase of 25bps per quarter (i.e. 25bps increases in Q3 and Q4 of 2015).

Because the state of the economy has changed since Yellen’s speech, it’s possible that the appropriate speed of rate hikes has changed as well. However, we find when running our own optimal control simulations that this is not the case. Using a small-scale model of the U.S. economy, we first projected a path for the funds rate assuming economic conditions similar to last November—when the unemployment rate was around 8% and Personal Consumption Expenditures (PCE) inflation around 1.8%. We calibrated the model such that the result closely resembles Yellen’s optimal control funds rate path from her speech (dotted red line in Exhibit 2). We then updated the model with today’s economic conditions—which include a lower unemployment rate but also lower inflation (teal line). The model implies an earlier liftoff date for the funds rate but roughly the same pace of hiking—about 25bps per quarter.

The bond market is currently pricing in rate hikes at approximately this speed—at least if we ignore risk premia for the moment. Exhibit 3 shows current pricing of fed funds forward rates based on Eurodollar futures (adjusted for fed funds-LIBOR basis) and a hypothetical funds rate hiking cycle of 25bps per quarter. The two lines are essentially on top of each other, implying that the Fed’s new funds rate projections should mean very little for market pricing. However, one important caveat would be that this conclusion assumes little risk premia in Eurodollar futures. If in fact current market pricing incorporates some positive risk premia, then the true market expectation for the funds rate would be a little lower than shown on the chart. In that case, revealing Fed officials’ expected rate path could lead to higher forward rates in the 2016 and 2017 section of the yield curve.

Some observers have pointed out that the 2016 forecasts could show a sharply higher funds rate because at that time the economy should be close to equilibrium. However, this argument misses the logic of the optimal control approach, in which policymakers deliberately commit to keeping rates lower than they would normally to overcome zero lower bound constraints. For instance, in Yellen’s simulations, the unemployment rate reaches 6% in the middle of 2016 and the inflation rate is actually above target at that time. However, the “optimal” funds rate at that point is less than 0.5%. The September SEP will likely show a funds rate path well-below that implied by traditional Taylor Rules—but investors know that Fed officials abandoned that approach last year.

The available evidence therefore suggests that when Fed officials begin raising the funds rate, they will likely proceed at about 25 basis points per quarter. This is on the slow side compared to history, but perhaps slightly above current market expectations, once we take risk premia into account.

To offset any possible negative reaction from publishing the 2016 forecasts, Fed officials could make a number of other changes at the September FOMC meeting, including lowering the unemployment threshold in the Evans Rule (possible but not likely, in my view) and/or trimming QE by only a small initial amount (looking increasingly likely).

1The optimal control simulations show a hypothetical “best” path for the federal funds rate, based on the structure of the economy and an assumption about policymakers’ preferences (i.e. the relative importance they place on inflation, unemployment, and possibly other factors).


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