The Federal Reserve is currently forecasting a “longer-term” Fed Funds Rate of 3.0%. Will they get there before the end of the current expansion? Let’s take look…

• Back in December 2008, the Fed cut rates down to a range of 0% to 0.25%, the lowest level in history. For 7 years they held rates at this level, by far the longest time spent at a trough level in history.

• In December 2015, December 2016, March 2017, and June 2017, they hiked rates by 0.25%, to a current range of 1.0% to 1.25%.

• The market (Fed Funds Futures) is currently projecting the next 0.25% hike to occur in June 2018 and only one additional hike through July 2020.

• The U.S. expansion is currently over 8 years in duration. The longest expansion in U.S. history was 10 years, from 1991 – 2001.

Given this backdrop, is 3% a realistic target before the cycle turns?

It doesn’t seem to be, unless a) the current expansion becomes the longest in history and b) the Fed significantly increases the pace of hikes, doing so against the expectations of market participants.

Observing the Fed’s behavior in recent years, this is unlikely. Their actual policy has been consistently more dovish than their own projected policy and much more in-line with the market:

• In March 2012, the Fed projected a 2014 year-end rate of 1.0% (implying 3-4 hikes). The actual target rate at the end of 2014: 0% – 0.25% (no hikes)
• In March 2013, the Fed projected a 2015 year-end rate of 1.0% (implying 3-4 hikes). The actual target rate at the end of 2015: 0.25% – 0.50% (1 hike).
• In March 2014, the Fed projected a 2016 year-end rate of 2.25% (implying 8-9 hikes). The actual target rate at the end of 2016: 0.50% – 0.75% (2 hikes).
• In March 2015, the Fed projected a 2017 year-end rate of 3.125% (implying 12-13 hikes). The current target rate is 1.0% – 1.25% (4 hikes) and is projected to remain there at year-end.
• In March 2016, the Fed projected a 2018 year-end rate of 3.0% (implying 12-13 hikes). The market is currently projecting a 2018 year-end rate of 1.42% (5 hikes).
• In March 2017, the Fed projected a 2019 year-end rate of 3.0% (implying 12-13 hikes). The market is currently projecting a 2019 year-end rate of 1.56% (6 hikes).

What if the Fed starts surprising market participants with hikes in upcoming meetings? Again, this is unlikely as there hasn’t been a surprise interest rate move in the current cycle. In an effort to squash volatility, the Fed has telegraphed each and every move far in advance and always met the market’s dovish expectations:

• From January 2009 through November 2015, the Fed was never expected to hike rates going into a meeting and the Fed delivered as expected, keeping rates at 0% to 0.25%.
• In December 2015, for the first time since 2006, the Fed was expected to hike rates. They did so and only hiked again in the December 2016, March 2017 and June 2017 meetings when they were expected to do so.

If this pattern continues, and the Fed is going to meet dovish market expectations, it will be extremely difficult to get to their 3% long-term target. They are much more likely to move their projections lower than to meet them. The Fed has already moved their long-term projections down from 4.25% to 3.0%, and when they meet again in September we should not be surprised to see this trend to continue.

Why?

1) Reported inflation remains subdued, below the Fed’s 2% target.

2) The rest of the developed world continues to maintain an extraordinarily easy monetary policies, with negative real interest rates across the board.

3) Most importantly: the Fed has never once expressed any real concern about unintended negative consequences from keeping rates artificially low for so long. They have only expressed their steadfast belief that easy money has been exceedingly positive for household wealth (higher stock prices/housing prices) and the real economy (via the “wealth effect”).

While some market participants are fretting about another Fed-induced “bubble,” this the last thing the Fed is concerned about. Quite the opposite is true, as stated plainly by Ben Bernanke in an Op-ed back in 2010. They want higher asset prices:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

If there are no negative consequences to easy money, then easy money becomes the default policy. If higher stock prices only lead to higher confidence, increased spending, and higher income, then a forever higher stock market becomes the default target. Any time stock prices go down, you ease (ex: a new round of quantitative easing) or slow the pace of normalization.

In a model that is optimized for asset price inflation, this is perfectly rational behavior. The question is whether a model optimized for long-term real economic growth would look the same. Put simply, is easy money as good for the real economy as it is for the stock market? As we cannot prove the counterfactual (normalized monetary policy years ago), that’s a question that can never really be answered. Which is another reason why the Fed is likely to continue to error on the dovish side, as they can take all of the credit for positive outcomes while arguing that any negative outcomes would be far worse but for their heroic easy money policies. A charmed life indeed.