FED RATE MOVE WILL MAKE DOVES CRY / THE WALL STREET JOURNAL

Heard on the Street

Fed Rate Move Will Make Doves Cry

The market isn’t prepared for a September rate increase, and the Federal Reserve will have a hard time changing that.

By Justin Lahart

May 14, 2015 2:00 p.m. ET
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Federal Reserve Chairwoman Janet Yellen faces a challenge in preparing the market for the central bank’s eventual rate increases. Photo: Jacquelyn Martin/Associated Press

The Federal Reserve wants to avoid sparking another taper tantrum. That will be easier said than done.

In May 2013, when the Fed’s then-Chairman Ben Bernanke said that the central bank could begin winding down quantitative easing “in the next few meetings,” he sparked a selloff in Treasurys that sent the yield on the 10-year note from 1.94% to 2.9% in three months.

By then the Fed was having second thoughts, in part because it worried the rise in long-term rates was damping the economy. It didn’t begin scaling back bond purchases until the start of last year. If it mishandles communicating its plans for raising rates, it risks a repeat.

The Wall Street Journal’s monthly survey of economists, released Thursday, shows that nearly three-quarters of forecasters expect the Fed to begin raising its target range on overnight rates at its September meeting. The remainder are split between earlier and later dates. The median federal-funds forecast for year-end is 0.625%, which implies a target range of 0.5% to 0.75%—implying two quarter-point increases from the current range.

Those forecasts reflect a view that the economy will rebound from the weak first quarter, allowing the Fed to finally lift rates. It also seems squarely in line with what Fed officials themselves expect.

 

But investors see things differently.

Federal-funds futures, which price off overnight interest-rate expectations, imply the chances of a rate increase by September are less than 50% and price in just one increase in the target range.

This view of a lower rate trajectory may reflect worries that some sort of shock disrupts the Fed’s plans, rather than a straight forecast of what the Fed will most likely do. But on balance, it seems like investors have a more dovish take than the economists.

It can be helpful to think of the implied fed-funds rate odds as reflecting a distribution. There are some investors who are completely on board with a September tightening, some who give it even chances, some who see later this year as more likely—and some who don’t think any increase will happen this year.

It is this last group—who are likely enamored of sectors paying big dividends, such as utilities and master limited partnerships—the Fed has to worry about. Just like the fraction of investors who were caught completely offside by Mr. Bernanke’s comments in 2013, they might have to adjust very quickly to a September rate increase, sending long-term rates higher than the Fed wants. Hence, one reason Fed officials lately have been saying markets need to figure out where rates are headed, rather than expect signals from the central bank, may be to inject a little more uncertainty into dovish investors’ calculations.

But convincing the doves that their forecasts for the economy are too downbeat, or that their understanding of the Fed is wrong, is beyond the central bank’s powers. If the Fed does raise rates in September, these folks are going to be surprised—and inflict a few shocks of their own on vulnerable sectors.