Fed is Getting Serious

The big news today was not just another 25 basis point increase in the fed funds rate, but also the tougher tone of the statement and the dot charts.  The Committee believes the natural rate of unemployment is around 4.5%, but the actual rate is projected to be around 3.5% late this year and next year.  The implication for policy is obvious.  Also, the statement acknowledges that inflation is now very close to the 2% target.  The statement also dropped the line that said the funds rate would for some time stay below the long-run level.  That eliminated their “forward guidance” constraints and could be viewed as creating room for more aggressive moves if needed.  Policy normalization is proceeding as planned, said Chairman Powell.

The median prediction for the funds rate at year end is now 2.4%, versus 2.1% in March.  That means two more increases this year.  By the end of 2019, the rate is projected to be near 3% and only slightly higher in 2020.

Remember, also, that the pace of balance sheet reduction moves from $90 billion this quarter to $120 billion in the third quarter.  This, at a time when Treasury auctions are increasing in size almost every month.  More Treasury issuance and fewer Fed purchases would suggest that the future path of Treasury yields is upward.  The FOMC is likely to be sustaining that uptrend at least through next year.

Today we have a funds rate near 2% and a yield on the 10-year Treasury near 3%.  Even with some additional curve flattening, a funds rate near 2 1/2% at year-end would probably be associated with a 10-year yield in the 3 1/4% to 3 1/2% range.  That would imply negative returns on Treasuries maturities beyond seven years.


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