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The Speed of Fed Rate HikesColumbia Management

By Zach PandlAugust 20, 2013

For the last several months, talk of tapering has dominated the Fed debate. Although there remains someuncertainty around the detailssuch as how large the initial step might bemost observers now expect thFederal Reserve to begin slowing the pace of quantitative easing (QE) at the September 17-18 meeting.Attention is now turning to another major issue on next months agenda: the publication of Fed officialsforecasts for the funds rate in 2016. The Fed rolls forward the Summary of Economic Projections (SEP) bone year each September. This year the updated forecasts will take on added importance because the firsrate hike is expected in 2015 and the economy should be near full employment by 2016. They will thereforreveal important new information about the Feds reaction function by showing the speed of future rate hikfor the first time.

Past Fed communication offers a few clues about what this rate path might look like. In particular, ChairmBernanke fielded a few questions on this topic when the FOMC introduced the Evans Rule last DecemberHe emphasized two points: (1) that the speed of rate hikes would be gradual, and (2) that Vice Chair Yelle

optimal control1 simulations presented in a speech last November were along the lines of what they had mind. Here are the key quotes from the press conference transcripts:

My anticipation is that the removal of accommodation after the takeoff point, whenever that occurs, woube relatively gradual. I dont think were looking at a rapid increase the path that were basing thesenumbers on does not necessarily assume a rapid increase after [the unemployment rate reaches 6.5 assuming that inflation remains well controlled, which I fully anticipate, I think that the rate of increaserates would be moderate.

So, the kind of optimal policy path that Vice Chairman Yellen showed is indicative of the kinds of analysweve done. I mean, weve run it for a variety of different scenarios, different assumptions about modelsand so on, but the general character of that interest rate path, i.e., that it stays low until unemployment iin the vicinity of 6 or a little lower, and then rises relatively slowly, which goes back to the question thawas asked earlier, that it doesnt involve a rapid removal of accommodation after that point is reached.That is consistent with that kind of analysis, and thats the type of analysis that was not the only thing welooked at but was informative in our discussion.

So what might this look like in practice? In her November 13 speech, Vice Chair Yellens optimal controlsimulation showed an average increase in the funds rate of approximately 25 basis points (bps) per quarteor 100bps per year. Interestingly, this is roughly in line with the pace of rate hikes shown in the June SEP ate 2015. If we remove the four FOMC participants that are forecasting funds rate increases before 2015(because they are very far from the committee consensus), then the average projected funds rate for the eof 2015 equals 76bps (Exhibit 1). If at the time of the June FOMC meeting most participants expected thefirst rate hike in mid 2015, then these forecasts would also imply a pace of increase of 25bps per quarte(i.e. 25bps increases in Q3 and Q4 of 2015).

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Because the state of the economy has changed since Yellens speech, its possible that the appropriatespeed of rate hikes has changed as well. However, we find when running our own optimal controlsimulations that this is not the case. Using a small-scale model of the U.S. economy, we first projected apath for the funds rate assuming economic conditions similar to last Novemberwhen the unemployment

rate was around 8% and Personal Consumption Expenditures (PCE) inflation around 1.8%. We calibratedthe model such that the result closely resembles Yellens optimal control funds rate path from her speech(dotted red line in Exhibit 2). We then updated the model with todays economic conditionswhich includeower unemployment rate but also lower inflation (teal line). The model implies an earlier liftoff date for thefunds rate but roughly the same pace of hikingabout 25bps per quarter.

The bond market is currently pricing in rate hikes at approximately this speedat least if we ignore riskpremia for the moment. Exhibit 3 shows current pricing of fed funds forward rates based on Eurodollarfutures (adjusted for fed funds-LIBOR basis) and a hypothetical funds rate hiking cycle of 25bps per quarThe two lines are essentially on top of each other, implying that the Feds new funds rate projections shoumean very little for market pricing. However, one important caveat would be that this conclusion assumes

ittle risk premia in Eurodollar futures. If in fact current market pricing incorporates some positive risk premthen the true market expectation for the funds rate would be a little lower than shown on the chart. In thatcase, revealing Fed officials expected rate path could lead to higher forward rates in the 2016 and 2017section of the yield curve.

Some observers have pointed out that the 2016 forecasts could show a sharply higher funds rate becausethat time the economy should be close to equilibrium. However, this argument misses the logic of the optimcontrol approach, in which policymakers deliberately commit to keeping rates lower than they would normato overcome zero lower bound constraints. For instance, in Yellens simulations, the unemployment ratereaches 6% in the middle of 2016 and the inflation rate is actually above target at that time. However, theoptimal funds rate at that point is less than 0.5%. The September SEP will likely show a funds rate pathwell-below that implied by traditional Taylor Rulesbut investors know that Fed officials abandoned thatapproach last year.

The available evidence therefore suggests that when Fed officials begin raising the funds rate, they will likproceed at about 25 basis points per quarter. This is on the slow side compared to history, but perhapsslightly above current market expectations, once we take risk premia into account.

To offset any possible negative reaction from publishing the 2016 forecasts, Fed officials could make anumber of other changes at the September FOMC meeting, including lowering the unemployment threshon the Evans Rule (possible but not likely, in my view) and/or trimming QE by only a small initial amount(looking increasingly likely).

1The optimal control simulations show a hypothetical best path for the federal funds rate, based on thestructure of the economy and an assumption about policymakers preferences (i.e. the relative importancethey place on inflation, unemployment, and possibly other factors).

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Disclosure

The views expressed are as of 8/19/13, may change as market or other conditions change, and mdiffer from views expressed by other Columbia Management Investment Advisers, LLC (CMIA)

associates or affiliates. Actual investments or investment decisions made by CMIA and itsaffiliates, whether for its own account or on behalf of clients, will not necessarily reflect the viewexpressed. This information is not intended to provide investment advice and does not account fondividual investor circumstances. Investment decisions should always be made based on annvestor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset

classes described may not be suitable for all investors. Past performance does not guaranteefuture results and no forecast should be considered a guarantee either. Since economic and marconditions change frequently, there can be no assurance that the trends described here willcontinue or that the forecasts are accurate.

This material may contain certain statements that may be deemed forward-looking. Please note t

any such statements are not guarantees of any future performance and actual results ordevelopments may differ materially from those discussed. There is no guarantee that investmentobjectives will be achieved or that any particular investment will be profitable.

There are risks associated with fixed income investments, including credit risk, interest rate riskand prepayment and extension risk. In general, bond prices rise when interest rates fall and viceversa. This effect is more pronounced for longer-term securities.

nvestment products are not federally or FDIC-insured, are not deposits or obligations of, orguaranteed by any financial institution, and involve investment risks including possible loss ofprincipal and fluctuation in value.

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