The Fed: What Is Different This Time?

 

 

We are trained to be skeptical when someone says this time is different.  It is often meant to justify some excess.  However, we still need to be sensitive to changing circumstances and relationships.  

There are three ways that this monetary cycle is objectively different than past cycles.  First, the Fed has adopted a target range for Fed funds as opposed to a fixed level target.  Second, the central bank pays interest on excess reserves.  Third, the size of the Fed’s balance has become a new tool that did not exist previously. 

These differences are critical in trying to decipher what has been discounted by investors.  For example, many investors and analysts, including ourselves, have made an assumption about where Fed funds will trade relative to the range.   The general assumption is that the effective rate (which is adjusted for the size of transactions) will be in the middle of the range.  The logic to the assumption was that in the current 0-25 bp range, the effective Fed funds average over the past 100 days has been 13 bp–the middle of the range.    

Like others, we assumed that after the first rate hike, the new target range will be 25 to 50 bp and that the Fed funds effective average will be 37 or 38 bp.   If Fed funds average 13 bp in the first 17 days of September, and the Fed hikes 25 bp at that meeting, and Fed funds average 37 bp for the remainder of the month, then fair value of the Sept Fed funds contract is 23.4 bp (23.8 bp if Fed funds average 38 bp in the last 13 days of the month).    The current implied yield of the contract is 17 bp. This is equivalent to about a 40% chance of a hike has been discounted.  

What if this assumption is wrong?   Maybe Fed funds are averaging the middle of the range primarily because of some distortion of the zero bound.    To minimize the risk of a dramatic market (over)reaction, the Fed may couch the hike verbally by highlight the gradual pace of increases and the likelihood that the terminal rate is considerably lower in past cycles.  Indeed, the July FOMC minutes suggested as much.