UNIQA Capital Markets Weekly

USA: The US central bank Fed hiked the key interest rate last week, as expected
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  • Taylor rules seem overall in line with the rate hiking cycle.
  • The natural rate of interest and term premia shed some light on understanding the Fed projections.
  • The market implied risk-neutral 10Y treasury yield is at 3.2 %. The term premium remains negative.

Press release (7281 Characters)Plain text

  • Taylor rules seem overall in line with the rate hiking cycle.
  • The natural rate of interest and term premia shed some light on understanding the Fed projections.
  • The market implied risk-neutral 10Y treasury yield is at 3.2 %. The term premium remains negative.

The Federal Open Market Committee (FOMC) of the US central bank Fed decided last week to raise the target range by 25 basis points to a range between 1.5 and 1.75 %. It was the sixth hike of the federal funds rate since the Fed embarked on an interest rate hiking cycle in December 2015 and the move was broadly anticipated.
Since the FOMC met in January, the labor market has continued to strengthen and economic activity has been rising at a moderate rate. Job gains have been strong in recent months (non-farm payrolls rose by 313.000 in February) and the unemployment rate has stayed low (4.1 %). The committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation is expected to move up in coming months and to stabilize around the Fed’s 2 % objective over the medium term.
The economic outlook has strengthened in recent months. In the quarterly Summary of Economic Projections (SEP) of the Fed (released last week), the median forecast for growth in real GDP increased to 2.7 % for 2018 and 2.4 % for 2019 (compared to 2.5 % and 2.1 % in December and 2.1 % and 2.0 % in the September SEP). The outlook for inflation remained mostly unchanged. The median projections for personal consumption expenditure (PCE) inflation (the Fed’s preferred inflation measure) are 1.9 % in 2018 and 2.0 % in 2019. According to the FOMC member’s expectations about the key interest rate, there are 2 further rate increases (each 25 basis points) envisaged for 2018 and 3 respectively 2 moves each in 2019 and 2020. Interestingly, the longer run projection for the neutral level of the federal funds rate (the level that is consistent with potential growth and stable inflation around the target) increased to 2.9 % (from 2.8 % previously).
Taylor rules are monetary policy rules that describe the response of the federal funds rate to changes in the price level and the output gap, defined as the percentage difference between actual output and the economy’s productive potential (see PDF). 

 Usually, policymakers do not follow these rules mechanically and, presumably, there is no particular specification that the FOMC prefers versus another. Nevertheless, monetary policy seems roughly in line with three different specifications of the Taylor rule, although two rules (Taylor rule, balanced rule) suggest that the policy stance is accommodative relative to the level of the federal funds rate that is suggested by these rules.
Some of these rules involve an estimate about the longer-run real neutral interest rate, which is often called the real natural rate of interest or “R*”, and which describes the level of the fed funds rate that is consistent with output equalling its potential and stable inflation (see PDF).
The graph shows the remarkable decline since around 2000 of the quarterly estimate of R* (as well as a smoothed time series of the variable). The natural rate is a persistent variable and, hence, it changes slowly. The latest value for Q4 2017 was at 0.4 % and it compares to the longer-run real neutral Fed funds rate of 0.9 % according the SEP (adjusted for 2 % inflation). Hence, this would suggest that the FOMC assumes a gradual increase in the neutral interest rate level over the next years.
The natural rate can be seen as an important anchor for risk-neutral long-term US treasury yields.  Methodologically, risk-neutral yields are understood as the average of short-term risk-free yields over the maturity of an investment. The difference between the observed yield and its risk-neutral equivalent is called the term premium.  Based on a term premium model by the NY Fed, we can decompose the US 10Y treasury yield in its risk-neutral component and its term premium.  

The market implied risk-neutral rate is currently 3.2 % while the 10Y US treasury yield is 2.84 % (zero-coupon). Given that the risk-neutral rate is already above the Fed’s longer run nominal neutral rate suggests that without a further significant acceleration of the expected rate hiking cycle only an increase in the term premium has the potential to push rates higher. Expectations of the Fed’s rate hiking cycle have been pushing yields up continuously since September 2017 already.  A long-term perspective on the term premium shows that since the early 1960s the term premium has increased to reach levels around 4 % in the 1980s from where it has followed a trend decline reaching negative territory in 2016.

Last week’s rate hike by the US Fed didn’t come as a surprise. The rate hiking cycle continues as expected and the medium-term growth outlook has been revised to the upside. Monetary policy remains accommodative, the long-run neutral rate is expected to rise moderately over the medium-term and increases in the term premium remain a potential upside risk for yields.


Martin Ertl   Franz Zobl 
 Chief Economist  Economist
 UNIQA Capital Markets GmbH  UNIQA Capital Markets GmbH

This publication is neither a marketing document nor a financial analysis. It merely contains information on general economic data. Despite thorough research and the use of reliable data sources, we cannot be held responsible for the completeness, correctness, currentness or accuracy of the data provided in this publication.
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Information on general economic data.


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