Wednesday Is ‘Fed Day’

The Federal Reserve in Washington on Aug. 22, 2018. Chris Wattie/Reuters

Commentary

On Sept. 16, at 11:15 am PT/2:15 pm ET, the U.S. central bank is expected to make some of the most heavily anticipated statements it has made in a long time.

That afternoon, the Federal Reserve will conclude a regularly scheduled meeting of its Federal Open Market Committee (FOMC)—the body that sets overnight interest rates and has, for the last 12 years or so, been in the business of directly manipulating other U.S. interest rates as well.

New Inflation Target?

As part of its set of announcements, the FOMC is expected to make some sort of statement about its new inflation target. This in particular is one of the most heavily anticipated aspects of any FOMC statement for some time. Until recently, the Federal Reserve had targeted U.S. inflation to be between zero and 2 percent. It was desired never to be negative so that banks and other lenders could trust that the value of the collateral on their loans wouldn’t all go down simply because the Fed wasn’t creating enough money.

On the other hand, all central banks have the institutional memory that hyperinflation in 1930s Germany was one of the proximate causes that encouraged the German population to vote Adolf Hitler into power. Furthermore, what happened in the 1970s in the United States and other industrial economies showed that if any inflation is allowed to exist, it can accelerate in subsequent years to go higher and higher because union contracts will demand higher cost-of-living increases, which, in turn, cause even higher inflation.

So, until recently, 2 percent had been the upper limit of what the Fed was willing to tolerate for inflation.

What changed, though, recently, is that the Fed now seems to be willing to tolerate inflation higher than 2 percent for some amount of time, so that the average is about 2 percent. From a functional perspective, this may mean that the target range is now more like 1 percent to 3 percent or 1.5 percent to 2.5 percent. We will learn more just after midday on Sept. 16. We will be commenting very soon after the Fed’s announcement as to what was said and what it means.

The other important information expected to be learned is what the FOMC monetary-policy-setting committee members expect for forward overnight interest rates (the so-called federal funds rate), inflation, and unemployment.

Currently, “the markets” expect overnight interest rates to remain at about zero through at least July 2022. I make this claim based on futures contracts for the fed funds rate, for which futures contracts trade on the Chicago Mercantile Exchange.

If the FOMC members’ own projections differ markedly from this expectation, markets will certainly pay attention and take it into account in how they will assess the future path of interest rates.

As another source of information, we also look at The Wall Street Journal’s survey of Wall Street economists. The Journal asked the group of leading economists, “When do you expect growth, inflation and employment, under the Fed’s new framework, will be consistent with raising interest rates?” Only about 25 percent of responding economists say they expect the Fed to raise interest rates in 2021 or 2022, while about 26 percent expect the Fed to raise overnight interest rates sometime in 2023.

Another 21 percent think the Fed won’t increase rates until 2024, and still another 28 percent of respondents think interest rates won’t go up until after 2024.

Why This Matters

All interest rates in the United States are a function of inflation, expectations for future inflation, current demand for real income via “real” interest rates and expectations for future real interest rates. For example, currently, the interest rate on the 10-year Treasury bond is about 0.7 percent. From other parts of the bond market, we know that the bond markets think inflation will average about 1.7 percent over the next 10 years—providing a negative real return of about negative 1 percent. The negative real interest rate reflects how much income the bondholder receives after taking into account the wealth destruction caused by inflation (i.e., nominal, or stated, interest rate, and minus inflation).

With the 30-year mortgage rate now at about 3 percent for many borrowers, it seems that the actions of the Fed and Treasury Department have fixed the ills that were affecting the mortgage lending industry when the pandemic was first declared.

However, if investors’ inflation expectation switches from 1.7 percent to, say, 2.2 percent, which might be more in keeping with the Fed’s Sept. 16 announcement—all interest rates would reflect that 50 basis point increase in rates and would rise commensurably.

On the other hand, if the Fed says something that suggests lower future inflation than currently expected or lower “real” rates needed by investors, then interest rates can go down.

Currently, low interest rates are one of the major contributors to the very strong real estate market, as well as the very strong consumer spending we’re observing.

We’ll have to see what the Fed says.

But now we all know the stakes and why this announcement is so important

Tim Shaler is a professional investor and economist based in Southern California. He is a regular columnist for The Epoch Times, where he exclusively provides some of his original economic analysis.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.