“In general, financial market expectations are more pessimistic than ours,” Chicago Fed President Charles Evans said Tuesday at an investor conference in Hong Kong, according to Reuters.
His remarks echoed those of Boston Fed President Eric Rosengren a day earlier. He, too, worried that investors had gone too far in writing off the possibility of Fed action this year.
"My own sense is that financial markets may have reacted too strongly," Rosengren said.
How far apart is the Fed from Wall Street? Here’s a chart from Evans’s presentation that illustrates the point. The dots represent central bank officials’ rate projections, and the solid line represents those of investors.
Both Evans and Rosengren historically have been among the lowest dots. In other words, they have been among the most cautious at the central bank in supporting increases in interest rates. Fed officials do not often speak directly to market expectations, which can be subject to large and frequent shifts. So it’s notable when they do address the issue, and it’s even more significant that the pushback comes from two officials whose views are probably most closely aligned with Wall Street’s.
The irony is that the Fed’s forecasts and investor expectations have actually been moving closer this year. When the central bank raised rates in December for the first time in nearly a decade, it projected it would move four more times this year.
But wild swings in world stock markets, a surprise drop in oil prices and downgrades to global growth spooked investors. Some financial indicators pointed to rising risk of another U.S. recession. In February, the futures markets indicated there was a 60 percent chance that the Fed would not hike again in 2016.
Yet officials did little to rein in those projections at the time. As a result, expectations of a more lenient Fed helped send yields on the 10-year Treasury to the lowest level in about a year, pushing down long-term interest rates such as mortgages. In fact, mortgage rates dropped in February despite many economists’ forecast that they would rise after the Fed’s historic increase.
Translation: Market pessimism about the economy was actually working in the Fed’s favor. Federal Reserve Chair Janet Yellen has twice cited the declining expectations for rate hikes as an important buffer for the U.S. recovery. In a speech last week, she said the shift “offset the contractionary effects of somewhat less favorable financial conditions and slower foreign growth.”
Yellen was even more explicit during a news conference following the Fed’s meeting last month.
“Market expectations for the path of policy interest rates have moved down, and the accompanying decline in longer-term interest rates should help cushion any possible adverse effects on domestic economic activity. Indeed, while stock prices have fallen slightly since the December meeting and spreads of investment-grade corporate bond yields over those on comparable-maturity Treasury securities have risen, mortgage rates and corporate borrowing costs have moved lower.”
But if market pessimism has been so helpful, why are some officials starting to push back -- especially now that investors' outlook is no longer quite so dire? Investors are now betting there will be one rate increase. The Fed’s latest projections show it anticipates two. That's certainly better than zero vs. four.
But if the Fed is right, the next increase probably would come in June. Evans has been relatively explicit on this matter as well, saying a rate hike could occur “in the middle of the year.” That’s only about two months away, and investors seem unprepared for the possibility of action. Markets do not anticipate the rate hike will come until the end of the year. The estimated chances of an increase in June were just 20 percent on Tuesday.
Are Fed officials starting to lay the groundwork for a rate increase? They clearly have a lot of convincing to do. Although investor pessimism has been a positive, the Fed should hope it doesn’t persist. Otherwise, the central bank risks surprising investors if it does raise rates in June -- potentially setting off another round of the financial turbulence of the kind that turned Wall Street so dour in the first place.
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