"Don't fight the Fed" is one of the oldest adages on Wall Street. But the financial markets remain at odds with the central bank's own projections for interest rates.
To little surprise of the markets, the Federal Open Market Committee Wednesday reaffirmed its intention that short-term interest rates would remain ultralow for a "considerable time," a bit of verbiage that some observers thought could be excised from the panel's policy statement.
But given the FOMC still saw "significant underutilization of labor resources" even job market conditions "improved somewhat further" since its last get-together in July, the panel kept policy on its glide path. That meant further tapering of its asset purchases, to $15 billion a month, with completion slated after the October confab.
Despite the FOMC's retention of the "considerable time" expectation for ultralow short-term rates, the various Fed officials' projections for the key federal-funds rate targets for the end of 2015 and 2016 were nudged up since their set of forecasts were released following the June meeting.
The median projection for the fed-funds target for the end of next year was 1.38%, up from 1.13% three months ago, according to the "dot plot" from the graph of the individual Fed officials' rate expectations. For end-2016, their median projection is 2.88%, up from 2.50% previously.
While still ultralow by historical standards, those rates are considerably higher than what the fed-funds futures market is pricing in. The December 2015 contract implicitly says the funds rate will average 0.775%—some 60 basis points (0.6 percentage points) less than the Fed officials' median expectation.
Given that the fed-funds rate is starting near absolute zero (technically, 0-0.25%), where it's stood since the nadir of the financial crisis in December 2008, 60 basis points is a significant difference of opinion.
For December 2016, the fed-funds futures contracts are discounting a funds target of 1.86%—more than 100 basis points lower than the Fed solons. Lengthier fed-funds futures contracts tend to be relatively lightly traded, however. The December 2016 is pricing in a three-month Libor (London interbank offered rate) of 2.225%, which would be consistent with an overnight funds rate of just under 2%, but close enough to what the fed-funds futures are saying.
A recent paper from the San Francisco Fed highlighted the difference between the expectations of the FOMC and the markets. "The public might not give enough weight to how dependent the central bank's guidance is on both current and incoming data," the researchers wrote.
Fed Chair Janet Yellen repeatedly made this point in her post-meeting press conference, as colleague Michael Aneiro detailed. The discrepancy between the expectations of Fed and the market, she observed, may have to do with the latter's different views on the economy.
While the FOMC shaved its "central tendency" of forecasts of gross domestic product for 2014—to a range of 2.1%-2.3% from 2.8%-3.0% previously—that mainly was to reflect the first quarter's weather-related 2.1% annual rate of contraction. The predictions for the next two years, which are far more important, remain intact, at 3.0%-3.2% and 2.5%-3.0% for 2015 and 2016, respectively.
As for unemployment, the FOMC trimmed its projections, again to mark them down in line with the sharper-than-expected decline this year. From a range of 6.0-6.1% for 2014, it sees the jobless rate dipping to 5.4%-5.7% in 2015 (from 5.6%-5.9% previously) and 5.1%-5.5% in 2016 (from 5.2%-5.6% previously). Moreover, that means the unemployment rate will be at or near to the FOMC's "longer run" projection sometime in the next two years.
Inflation, meanwhile, is projected to remain contained, below the Fed's 2% target for the next two years. That forecast got some bolstering with the drop in the consumer price index in July, the first in almost one and a half years, of 0.2%. On a year-on-year basis, the CPI is up 1.7%.
Even so, two FOMC members—Richard Fisher and Charles Plosser, respectively presidents of the Dallas and Philadelphia district banks, both dissented from the decision. Fisher thought an earlier first fed-funds rate hike was warranted by the economy while Plosser reiterated his dissent that the "considerable period" phrase was "time dependent" and didn't reflect the economy's recovery.
But the futures market is casting its dissent in the other direction—that the Fed officials are wrong in expecting faster and bigger rate hikes. That would seem to be a reflection of the markets' recognition that the Fed's forecasts for economic growth have proved mostly too optimistic.
Thus, the central bank thinks the U.S. economy is on a path for sustainable 3% growth while the futures market thinks it remains in its "New Normal" path around 2%. The latter seems okay with the stock market as the major averages edged up, with the Dow Jones Industrial Average ending at another record.
The market is implicitly betting the forecasting abilities of Yellen & Co. haven't improved. If so, better to watch what the Fed does than what it says it will do.