The Big Idea
A brief history of Fed policy expectations
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The past few months have seen one of the largest and most abrupt revisions of market expectations for the Fed in decades. The past 20 years have seen the Fed keep policy rates relatively low and make only gradual and well-telegraphed changes. With inflation exploding higher as the economy recovers from pandemic, the Fed will not have the luxury of being “measured” or “patient.” Rather, the Fed is scrambling to catch inflation. One good bit of news is that the drastic shift in policy expectations has not created undesirable financial instability or a sharp markdown in economic prospects.
Comparing today to 2004-2006 and 2015-2018
The early stages of the current rate hike cycle are shaping up to be quite different from the last two cycles. There is clearly no comparison to the muted 2015-2018 rate hikes. Meanwhile, in the 2004-2006 period, the FOMC raised the funds rate target by 425 bp over two years, but the moves were made in steady 25 bp increments at 17 consecutive FOMC meetings and there was little uncertainty about the magnitude and timing of the Fed’s next move once the cycle got started.
In the run-up to the first rate hike in June 2004, there was an intense debate in the financial markets over whether the initial tightening would be 25 bp or 50 bp. Once the Fed started with 25 bp and included forward guidance in the FOMC statement that described the Fed’s approach as removing accommodation at a “measured pace,” fed funds futures never priced in more than 100 bp of tightening over the next six months, as quantified by the gap between the rolling 6-month-ahead fed funds futures contract and the actual funds rate target ( Exhibit 1).
Exhibit 1: 6-month-ahead fed funds futures tightening expectations: 2004
Source: Bloomberg, Federal Reserve.
Comparing today to 1994-1995
The closest analog to the current rate hike cycle in terms of pace and magnitude in recent history might be the 1994-1995 episode, when the Federal Reserve raised rates by 300 bp in a year, taking the funds rate from 3% to 6%. However, one key difference between 1994 and the current cycle is that expectations were muted to start and only ramped up later. The day before the first rate hike in 1994, which occurred February 4, the 6-month ahead fed funds futures contract indicated that investors were pricing in a modest 59 bp of rate hikes over the next six months (Exhibit 2). That expectation remained in a range between 50 bp and 100 bp until May, when the Fed raised rates by 50 bp for the first time in the cycle. In fact, it was not until the late stages of the cycle, in the fourth quarter of 1994, before 6-month expectations peaked in the neighborhood of 160 bp to 180 bp.
Exhibit 2: 6-Month-ahead fed funds futures tightening expectations: 1994
Source: Bloomberg, Federal Reserve.
Indeed, as it turned out, market expectations for Fed tightening in late 1994 well overshot what actually happened. The 6-month-ahead fed funds futures contract surged above 7% in December 1994, when the actual funds rate was 5.50%, but the Fed ended up stopping at 6%.
The current cycle
Compared to these two earlier cycles, the beginning of the current rate hike campaign has been far more tumultuous. While expectations six months ahead were quite restrained through late January, the implied amount of rate hikes priced in for the next six months has steadily ratcheted higher since then. It hit 100 bp in February, dipped briefly at the onset of the Russian invasion of Ukraine, and then resumed a rapid uptrend, reaching 160 bp this week, a level rarely reached in 1994 and mainly near the end of the cycle (Exhibit 3).
Exhibit 3: 6-Month-ahead fed funds futures tightening expectations: 2022
Source: Bloomberg, Federal Reserve.
The ascent of expectations for tightening within a 6-month window since the beginning of the year has actually been similar in magnitude to the experience of 1994. Over the three months from mid-February (just after liftoff) to mid-May in 1994, financial markets went from pricing in 40 bp of rate hikes to 160 bp, though, to be fair, that peak was fleeting and expectations for further tightening receded substantially after the FOMC’s 50 bp rate hike in May. This year, from late-January to April 21, also a 3-month stretch, rate hike expectations surged from less than 50 bp to more than 160 bp.
The main difference from 1994 to today is that financial markets saw the rate hikes coming earlier and began pricing them in before the fact. This reflects the main substantive difference between 1994 and this year, which bears importantly on the Fed’s prospects for success. In 1994, Chairman Greenspan and company raised rates pre-emptively and were able to fend off a sharp increase in inflation. In contrast, Chair Powell’s Fed explicitly ruled out pre-emptive moves with its change in framework implemented in 2020 and then waited until well after inflation had accelerated to begin to unwind their extraordinarily stimulative stance.
Peak of the cycle
There has also been a rapid evolution in the expected peak fed funds rate for the upcoming cycle so far this year. The September 2023 3-month SOFR futures contract has provided a decent proxy for where investors expect the rate hike cycle to top out. Six weeks ago, on March 7, the contract yielded 1.89%. It has soared by over 140 bp since then and was trading on April 21 at just over 3.30%.
While the eventual peak of the cycle may well exceed that level, the bulk of the adjustment that was needed in the level of expected policy and thus in the level of various interest rates has occurred. Unlike in 1994, when that adjustment took place over an extended period, at least six months, today’s more forward-looking markets have accelerated the process, pricing in the bulk of the adjustment in a short period, just a couple of months.
Weathering the storm
One might imagine that such a massive shift in policy expectations could create significant economic ripple effects. It was not so long ago that many economists and market players were arguing that the economy would not be able to handle policy rates anywhere above 2% without dire market and economic consequences. As inflation has accelerated further in early 2022, those concerns have mostly receded. Indeed, over the past three months, stock prices have swung up and down but have been on balance roughly flat, absorbing both a drastic shift in Fed expectations and the implications of the Russian invasion of Ukraine with impressive composure.
Fed officials have expressed cautious optimism that they will be able to engineer a soft landing, avoiding a recession even as policy will likely move rapidly from exceedingly easy to restrictive. The economy retains tremendous momentum for now, so the Fed’s task of reining in inflation is likely to be challenging, perhaps much tougher than policymakers hope. Given the late start that the FOMC has gotten in fighting inflation, while I am also hopeful, I am concerned that policy may need to remain restrictive for an extended period of time to quench price pressures. Such a policy stance runs the risk of delivering a stretch of sub-par economic growth or possibly even a recession, but probably not until 2024 or 2025.
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