One of the imminent questions in the US fixed-income market is ‘when will the Federal Reserve (FED) raise its benchmark Federal Funds Rate?’. With the current target rate set between 0.00% – 0.25%, the FED will have to come to a decision, depending on the economic data of the next few months, on whether a rate hike is permissible in June 2015. I would like to argue that a June rate hike is highly improbable based on the economic data we have observed so far. Although the US is in a much better state than it was in 2007, recent data on employment and inflation suggest that the Federal Reserve conditions are unlikely to be met.
Federal Reserve conditions
On March 27, US Fed Chair Janet Yellen spoke to the press regarding the two conditions that must be met for a rate hike later this year. These two conditions are 1) maximum sustainable employment 2) an inflation of 2%. The following two sections will explore the conditions in greater detail.
Figure 1: Employment data
Figure 1 shows the headline unemployment rate, known as the U-3 (red line) and the U-6 (green line). Unemployment rate U-6 is different from U-3 because it includes two groups of people that the U-3 does not:
1. Marginally attached workers – people who are not actively looking for work but who have indicated that they want a job and have looked for work in the past 12 months.
2. Involuntary part-timers – people who are looking for full-time work but have settled on part-time work due to the difficulty of obtaining full-time work.
Since November 2010, the percentage of unemployed Americans as measured by both U-3 and U-6 has declined steadily. However, after the 2008 financial crisis the spread between U-3 and U-6 has widened (Figure 1). U-3 is currently at 5.5% while U-6 is at 10.9%. The spread between them is currently at 5.4% whereas the pre-crisis spread was around 4%. The faster drop in U-3 can be partly attributed to the steady drop in the labor force participation rate (Figure 2), which reduces the total population used to calculate U-3. The labor force participation rate is currently standing at 62.7% on March 2015. This was 64.2% on January 2011.
Figure 2: Labor Force Participation rate
During a key hearing on February 24, Yellen stated that the fact that the FED has not achieved the so-called maximum employment is partly due to the high U-6 figure.
Figure 3: Inflation data
The second condition is the target inflation rate of 2%. Figure 3 shows the Core Inflation Rate (solid line) and CPI (dotted line). The Core Inflation Rate differs from CPI in that it excludes commodities such as energy and food products, which are usually more volatile and can give a false measure of inflation. Core inflation rate is believed to be the figure most closely monitored by the FED. While inflation has been increasing for the past two months, it is unlikely to reach the target of 2% given its growth rate and uncertainty in inflation figures for the past 12-months.
Even if inflation hits 2%, I still believe it will take more than this figure for the FED to raise rates. In particular US economic growth, employment, and the future global economic state are factors that play a part in the FED’s decision function. With the possibility of a Grexit and slower GDP growth figures in China, the FED needs to consider seriously what would happen to the USD if the interest rates were to go up.
A type I error is more dangerous
Paul Krugman, Professor of Economics at Princeton University and a Nobel Laureate in Economics, stated on February 11 in his NY Times blog that the policy implications of a rate hike are asymmetrical. This has inspired me to think about FED rate policy in terms of Type I and Type II errors. In statistical hypothesis testing, a Type I error is the incorrect rejection of a true null hypothesis and a Type II error is the failure to reject a false null hypothesis. I would like to argue that a Type I error has more severe consequences for the FED than a Type II error. In this case, the null hypothesis is not raising the interest rate.
Figure 4: Type I and II errors in statistics
The FED is concerned with both inflation and unemployment in the economy. To explain why Type I is more serious than Type II, I would urge you to consider the case that FED wants to see if a rate hike is in proper order. If the FED raises the rate because it deems the US to be near full employment as measured by U-3, and this turns out to be wrong, the economy could sink below a 2% inflation as well as have higher unemployment. If the FED does nothing, inflation and employment rates might pick up possibly causing an overshoot. This is not as bad of a scenario as the former, since consumer prices have stagnated for years despite the FED attempting to raise it to the 2% target since January 2012.
The main market sentiment indicator of a FED rate hike is the CME Group FedWatch, which calculates the implied probabilities of rate hikes using CBOT 30-Day Federal Funds’ (FF) future contract prices.
Figure 5: Implied probability of a rate hike in June 2015 FF
Figure 5 shows the implied probabilities of a rate hike in June 2015 FF. The market has assigned a 2.14% probability to the rate going up to 0.5%, a 75% drop from the previous month’s figure. It seems that the market is rejecting the likelihood of a June rate hike.
The market is pricing in at least one rate hike for 2015, as seen in Figure 6 for January 2016 FF futures. As the market disregards June 2015 as a probable option, the implied probabilities for a rate hike in later periods, namely September, October, December 2015, and January 2016 FF futures have increased substantially. There is a 10% chance of a July hike, 27% in September, 45% in October, and 57% in December.
Figure 6: Implied probablities of rate hikes up to January 2016
Thoughts on the rate hike
Overall – the FED would not want to tip the US back into a recession. Current figures about inflation, unemployment, consumer spending, and the dollar do not justify a hike in Q2/2015. The FED previously mentioned that no matter when a rate hike will occur, the path will be “shallow”. Therefore, I do not believe that we will see a second hike in 2015.
July (10% hike) – Still too early. One more month of economic data isn’t going to alter the path of FED’s decisions, which have traditionally been cautious.
September (30% hike) – The consensus among many economists and investors alike, such as Allianz’s Mohamed A. El-Erian, is that the FED will begin raising rates in September at the earliest. I am slightly biased against a September hike, due to the strong US dollar, seen in Figure 7 and Figure 8.
Imports decline when the dollar goes up. However, the figures below contradict a normal state of the trade-currency relationship. The steep drop in import figures coincides with a lower import price, which downplays potential inflation gains. The inverse relationship between the dollar and import suggest that the US economy may not be quite there yet.
Figure 7: US Dollar Index versus US import prices
Figure 8: US Dollar Index versus total US imports
October (70% hike) – while the economists believe in September, traders have begun to predict an October hike, as can be deduced from the implied probabilities in the October FF. My belief is that an October hike is more likely than a September hike, although there is very little difference in in terms of the underlying economics.
December (95% hike) – I believe that by December some of the major problems plaguing the FED’s decision should have somewhat subdued. For instance, European exports could pick up on a weaker Euro, oil prices might stabilize higher, and the dollar may soften due to stronger currencies in oil-rich countries like Canada.
January 2016 (100% hike) – Continuing with the same logic as a December rate hike, by this point further economic data should convince the FED that the economy is in good shape for a rate hike.
Unemployment and inflation-rate predictions
Here, I am offering my predictions on the future paths of inflation and unemployment. Figure 9 and Figure 10 below are modelled using ARMA processes with seasonal lags and using data from the past 10 years. Forecasts are made on a monthly basis until the end of 2015. The forecasted figures suggest that inflation will tick up to 2% and unemployment will fall towards 5%, the rate of full employment as noted by some central bankers.
Figure 9: Inflation rate prediction
Figure 10: Unemployment rate prediction
Looking at the implied probabilities, the predicted paths of inflation and unemployment, as well as the USD, I would expect the USD to climb higher in December post-rate hike. I would long December Dollar Futures (DXZ15) on the basis that a US rate hike would increase the value of the dollar index against the basket of foreign currencies within the index. My target for the index is between 105 – 110 by the end of 2015.
Note: the implied forward rates for each currency-pair in the index is calculated using FT=S0×((1+RDC)^T)/(1+RFC)^T), where RDC is the US interest rate, RFC is the foreign interest rate, and S0 is quoted in USD per unit of foreign currency. If the US interest rate goes up in December, the dollar index will increase, keeping foreign interest rates constant.
Figure 11: December Dollar Futures (DXZ15) price chart
Given the state of the US economy as well as the many uncertainties surrounding international markets, I believe the Fed is unlikely to raise interest rates in June 2015. My belief is that there will be one hike in 2015 and it is likely to occur between September and December 2015.
There are signs that the US economy is rebounding, such as weekly data on jobless claims, chain store sales, mortgage applications, and bank lending. Among the other variables contributing to a rate hike, the Grexit as well as a strong USD should be of concern. Lack of agreement on payment schedules for Greece may add more volatility to the equity market and create an additional demand for US treasuries, forcing current effective rates to lower and the US dollar to strengthen.
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Allen is currently a master’s student in financial economics at Western University. He is passionate about the financial markets with particular focuses on US and Canada.