This week Roger has enlisted an esteemed colleague in our NY office, Alexander Pelle, to take a deeper look at market-based forecasts for the FED Funds Rate. What can we learn from previous mistakes? – Quite a lot, it seems!
Previous posts of Macro n’ Cheese have visualized the Fed Funds Future Curve along with the “dot plot” policy rate forecast (We will have an even better one soon—promise!). The over-optimism of the dot plot forecasts has been well noted. Here we can see clearly that the FOMC’s projections of the policy rate in the “longer run” have been revised downwards dramatically over the current expansion.
Market-based expectations of the Fed’s policy path can also be estimated from the Fed Funds futures market. As has been widely noted, market expectations of the future policy path have shifted drastically since the December 2018 Fed meeting. Probabilities for different rate levels can be imputed from Fed Funds Futures prices. At present this suggests that the probability of a rate cut by year-end 2019 is nearly 98% (the probability of hike is 0.000%).
Just like the dot plot, the Fed Funds Futures curve, as a market-based estimate of the future policy rate path, has been subject to substantial forecast error. The chart below shows the FF Future curve on every Fed meeting day since 1988 (pink) with major geopolitical & market events (dark blue) overlaid along with the FF policy target midpoint, the FF effective rate, and NBER recessions (shaded blue).
If we take the mean of the Fed Funds Futures at each meeting day over the last 30 years and subtract the effective FFR (after all the Fed Funds market rate does deviate from policy target) to measure the average forecast error over time, we can see substantial variation in forecast error over different stages of the economic cycle.
When the economy is in a state of steady expansion and interest rate policy is fairly constant, such as the mid 90s and most of the 2010s—constant 0 but nonetheless!–, the Fed Funds Futures Curve seems to be a decent estimate (relatively at least) of the future FF rate.
However, during times of change—either during periods of tightening or easing—the absolute forecast error of FF Futures market increases. During tightening cycles (shaded blue in the chart below)—with the big exception of the most recent tightening cycle—the FF Future market has underestimated the pace of rate hikes. During easing cycles (shaded peach in the chart below), the FF Futures market has a record of over-estimating the future federal funds rate—meaning the Fed tends to cut more drastically during recessions than the market predicts.
This record may have implications for monetary policy transmission. In particular there is evidence of “substantial lags” between monetary policy action and its transmission to financial markets and the real economy, as Larry Summers warns, but in terms of forecast error, it is also instructive.
On the one hand, for those who believe the economic expansion still has room to run (not many outside the FOMC apparently), the large forecast error of Fed Funds Futures in the past suggests market-based projections are generally poor estimates of future Fed policy. Indeed, if our baseline forecast is that the Fed will keep rates constant until year end, the current average forecast error is in line with the relatively minor past variation during periods of steady expansion.
Winter is coming
On the other hand, if one believes that the economic expansion is on its last leg and the Fed’s next rate move will be a cut, then history suggests that the current projections for cuts are in fact too modest. In the post-War period, the Fed typically cuts rates suddenly and dramatically–approximately 5%–in a recession, and market participants have a poor record in predicting the magnitude of the Fed’s change of policy course. If the economy tips into recession, history suggests the Fed’s easing will manifest in rate cuts that are far more drastic than those currently projected by market participants.
*Charts and commentary by Alex Pelle