Whither Rates

July 8, 2006

Summary: The Fed is probably going to raise rates another 50 basis point during the second half of 2007, after which it will probably start a multi-year descent.

Here’s a graph that shows the Fed Funds rate and the 30-Year mortgage rate from 1972 to mid-2006.

  • There has rarely been a time in this period where the rise in Fed Funds rate has not been accompanied by a rise in Mortgage rates.
  • The duration for which the Fed has raised rates has varied considerably, but the current uptrend has been slightly above average, in terms of duration and quantity of increase. Therefore, by “naive” historical pattern, one would expect the Fed to pause and begin to let rates go back down again.
  • Given that the Fed has a new Chairman, he wants to prove himself good at controlling inlfation and also wants to show that he does not stifle growth. However, with current ideology what it is, the chances are that if he has to err, it will be on the side of wanting to control inflation. The current ideology would therefore point to a little more of a raise, until the economy actually squeals just a little bit.
  • In 2000, the Fed took the rate just above 6%, to “kill the bubble”. Chances are it will want to stop shy of that, since it’s hard to see that the Fed perceives as much of a bubble today as in 2000.
  • The net of this would be an expectation that the Fed will raise rates another 50 basis points over the latter half of this year (perhaps with a skipped meeting during which they will pasue). Then, they will probably pause again and go back to dropping rates.
  • The speed at which they resume dropping rates would depend on whether something hits, particularly on how housing fairs in some of the frothy markets.


Update (July 28th): We’re about a week away from the next FOMC meeting. In the meanwhile, Bernarnke spoke about a slowing economy, causing people to speculate that he’s predicting a “soft landing”. While today’s GDP figures point to slower GDP and housing, they also point to a high (2.9%) jump in “core inflation”. From the Fed’s perspective, sticking with an August 8th hike, despite the slowing GDP will demonstrate their inflation-hawkinshness for good. I’m guessing they opt for a raise, rather than pausing this time and raising at the next meeting (which in their view would demonstrate that they are “reluctant raisers”).

Update Aug 04: PIMCO thinks the Fed is almost done, and see rates being eased in 2007. Also, in the morning, the jobs data came in lower than expected, with the official unemployment number going from 4.6% back to 4.8%. The market zoomed up briefly in an almost knee-jerk “ah! they will not raise rates” fashion. However, it was short-lived. In a couple of hours, it was going back down… not sure why.

Update Aug 9th 2006: In the end, the Fed did not raise rates. After an extremelt short and weak upturn, the market sunk. I figure that people realize that the rate cut is coming and has simply been postponed. So, rather than a quick end to the uptrend in rates, they see a longer, drawn out (though less steep) trend. In essence, the misery has been prolonged.

Update Oct 17th 2006: The Fed is in “pause mode” now, waiting to see what happens next. If inflation stays high for too long or goes further up, they might tighten again. On the other hand, if inflation seems low and the economy begins to slow (e.g. driven by below-inflation house-values) the Fed may start a lowering phase. Today, Goldman Sachs predicted that by the end of next year (i.e. end 2007) the Fed rate will drop from the current 5.25% to 4%. On the other hand, J.P.Morgan predicted that it will rise to 6%. (via Bloomberg)