Central bank policy and market expectations in the US 2022

Tapering coming to an end, interest rate hikes in sight

The US Federal Reserve began to tighten significantly the loose monetary policy of recent years during the fourth quarter of 2021. First, the gradual reduction of bond purchases was heralded in the November meeting and the pace of tapering was doubled to USD 30 billion less purchases per month in December. As a result, the Fed’s bond-buying programme will end as early as March 2022.

On the other hand, the Fed has also announced much faster rate hikes. The following chart shows the median of the Federal Open Market Committee’s (FOMC) members’ estimates of where US key interest rates should be in the coming years. These so-called “dot plots” are considered an important communication tool of the Fed regarding future interest rate policy.

As the chart shows, there was a significant tightening of expected monetary policy between the September and December Fed meetings. Although there has not yet been a rate hike for 2021, expectations for 2022 were 0.875% in December, 0.625% percentage points higher than three months earlier. For 2023, key interest rates are expected at 1.625% after 1% in September. Even for 2024, the Fed now sees key rates 0.375 percentage points higher at 2.125%. The reason for this rapid tightening of monetary policy is seen as rising inflation, which peaked in mid-December 2021 at 6.8% for the time being.

Differences in the longer-term interest rate forecast

While the market often follows the Fed’s short-term interest rate expectations very closely, there can be larger differences in the longer-term interest rate forecast. Figure 2 shows the market’s interest rate expectations derived from the implied interest rates of US money market futures. These depict the money market interest rates in the USA over the next ten years, which the Fed tries to steer with its interest rate policy.

As can be seen from the chart, the money market rates follow the Fed’s key interest rate expectations very closely over the next two years. In December 2023, the implied money market rate stands at 1.625% and thus exactly at the median Fed expectation for 2023. After that, however, a clear divergence of expectations can be seen. While the FOMC members see a further one-and-a-half interest rate hikes at the median for 2024, the market sees the rate hike cycle as largely over from December 2023. At the end of 2024, the market is pricing in a money market rate of 1.71%, at the end of 2025 of 1.72%. In fact, only one interest rate move above the December 2023 level is priced in for the next ten years; at no point until the end of 2031 are interest rates above 1.9%. A future convergence of these expectations may lead to significant interest rate movements in the market.

This discrepancy in longer-term expectations is also very clearly reflected in the development of government bond yields over the fourth quarter. The following chart shows the development of two-, ten- and thirty-year US government bond yields since the end of September 2021.

Short-term and long-term interest rates have different dynamics

A divergence between short and long maturities can also be seen in US Treasury yields. The two-year yield experienced a massive increase, rising from 0.28% at the end of September to 0.73% at the end of December, despite concerns about the fourth wave of Covid infections. Longer-term yields, on the other hand, were unimpressed. The ten-year yield moved sideways, ending the quarter two basis points higher at 1.51%, while the thirty-year US Treasury yield fell 14 basis points to 1.90%.

Thus, a clear flattening of the yield curves was seen over the quarter. The spread between ten-year and two-year yields fell by 43 basis points to 0.78%, and the spread between thirty-year and two-year yields fell by as much as 59 basis points to 1.17%. The market often associates such a sharp flattening with a significant decline in growth and thus inflation expectations. This market movement is an indication that the market views the Fed’s forecasts as too restrictive and thus inhibiting growth.

To put Fed and market expectations in a longer-term context, the following chart shows the history of key interest rates in the US since the early 1970s and the official recessions as determined by the National Bureau of Economic Research (NBER).

Figure 4 shows several interesting aspects. Firstly, it can be seen that since the inflation fight in the early 1980s, when the Fed raised the policy rate to 20%, each new interest rate cycle has reached a lower high than the previous one, while the rate cuts reached a new all-time low each time. While 20% had been reached in March 1980 and again in May 1981 after short-term rate cuts, policy rates fell to below 6% in late 1986. Subsequent interest rate cycles brought highs and lows of 9.75% and 3% (February 1989 and September 1992), 6.5% and 1% (May 2000 and June 2003), 5.25% and 0.25% (June 2006 and December 2008), and 2.5% and 0.25% again (December 2018 and March 2020).

According to current market expectations, this pattern is likely to continue in the upcoming interest rate cycle. A frequently heard interpretation of this development is that the growth potential of the US has weakened over time and the maximum interest rate level that the real economy can tolerate has fallen significantly. If this is the case, fears of excessive interest rate increases, especially for longer maturities, should be misplaced.

A second insight of the chart is that every Fed rate hike cycle since the 1970s has ended in a recession. These recession phases are only determined by the NBER retrospectively, so when the recession occurs it is not always apparent to market participants. For example, in April 2008 Fed President Ben Bernanke predicted before the US Parliament that the US economy would not slide into recession, while its onset was retroactively determined to be December 2007. From the figure it can be seen that the beginning of each recession occurred around the interest rate peak or shortly thereafter. Based on the market’s interest rate expectations, this would mean negative economic growth in the US probably in the course of 2024.