What’s the future for US interest rates?

Following the outsize October Non-Farm Payrolls number last Friday the consensus of opinion in the market is that the Federal Reserve will raise rates at its December meeting. Fed Funds futures currently imply a 68% chance of a rise.

A new experience for many

If you were born in the early 1990s or later then, as an adult you have not experienced a Federal Reserve rate rise cycle (I feel very old typing those words) In fact we have to look back to the summer of 2004 to find the last time that Fed embarked on the upside leg of the interest rate cycle.

As we can see from the chart below of the Fed Funds rate (effectively US base rates) the Fed moved "quickly and constantly" in this prior cycle before it was forced to cut rates once more as the credit crunch emerged in the summer of 2007.

But what will be the trajectory of US interest rates over the next twelve to 24 months?

During the 2004 to 2007 cycle inflation remained consistently above three percent in the USA. Indeed rather perversely inflation continued to rise after interest rates moved lower in late 2007, when the credit crunch stated to bite, as annotated by the red ellipse in the chart below.

Inflation can be thought of as a measure of aggregate demand within an economy or if you prefer a surplus of money chasing a lesser supply of goods and services. Historically the net result of this imbalance between supply and demand would be rising prices or inflation. However things look rather different in today's globalized interconnected economies.

Absentee

In most developed economies the spectre of inflation (so often associated with the boom and bust economic cycles of the twentieth century) is a distant memory, though one that central bankers would like to conjure up into the present day.

The chart above tracks inflation in the USA measuring both the broad based rate of inflation alongside the narrower measure of core inflation (effectively inflation with the effects of Food and Energy prices stripped out) as we can see we have a sharp divergence between these two measures with core inflation rising as broader inflation falls back towards the zero bound.

This is most perplexing as historically core inflation has traditionally lagged behind broader measures. It may be that we need to reconfigure the metrics that we use to measure inflation to make them more representative of what's going on in the modern world but that's a discussion for another day.

Other measures

The St Louis Federal Reserve has recently introduced an alternative measure of inflationary forces which it has christened its price pressure index. The index attempts to quantify the likelihood of US inflation moving to, through and above 2.5% over the next twelve months. Currently the index shows zero chance of that happening. The Federal Reserve's inflation target is two percent, given the sharp decline in the price pressure index even that figure looks likely to prove elusive in the medium term.

Low and Slow

Given the above its seems likely that the Future path of US Interest rates will be low and slow and if we look at a chart of the yield curve of US T Bonds or government IOUs if you prefer. Then the market seems to be of a similar mind.

US Treasury bond Yield Curve (source US treasury)

As we can see from the chart above US the bond market believes that rates will remain below 1 % for at least the next two years and further concludes that it will take almost 7 years for rates to breech the two percent boundary.

Of course these projections can and do change quite regularly and they can be driven by factors other than economic data. Nonetheless such market measures serve as a very useful guide or benchmark.

The takeaway then is that even if the Fed do move in December it may be just a symbolic rise to prove that they can raise rates, rather than the first step in a headlong rush to normalisation.

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