What Does 'Gradual' Mean?

Economists have given Federal Reserve Chair Janet Yellen a mission for next week's press conference: Explain what “gradual” means.

The Federal Open Market Committee in September projected an interest rate policy path that, including December, averages four interest rate hikes a year through the end of 2018. That's half the pace of the last tightening campaign, when rates were raised by a quarter point every meeting from June 2004 until peaking two years later at 5.25 percent.

Sixty-four percent of economists surveyed by Bloomberg News from Dec. 8 to Dec. 10 said the quarterly forecasts that officials will publish Wednesday will show a slower path of increases than their September estimates. That's more in line with financial markets where prices on futures contracts for three-month Eurodollars—dollar deposits held at banks outside the U.S.—indicate about two increases in 2016.

“There are some pretty widely varying views on whether the Fed is ahead or behind the curve and whether inflation is going to pick up very quickly,” said Michael Hanson, senior economist at Bank of America Corp. in New York.

Almost all of the 91 economists in Bloomberg News' separate monthly survey see the Fed hiking by a quarter point, ending a seven-year era of near-zero rates.

Assuming the Fed raises rates on Wednesday, the second rate hike would likely come in March, according the highest average probability assigned by the 45 economists surveyed.

Yellen told the congressional Joint Economic Committee Dec. 3 that the “gradual” pace of interest rate increases was linked to her assumption that the so-called neutral rate—which keeps supply and demand in balance in the economy—is low just now.

“It is a factor that leads us to believe that even when we start raising rates, that those rate increases will be gradual,” Yellen said in response to a question at the hearing.

The neutral, or equilibrium, rate changes through time, and Fed officials in September estimated that in the long run it will settle at around 3.5 percent, or 1.5 percent in real terms subtracting for 2 percent inflation, which is the Fed's goal.

Economists in the survey are more optimistic, with their median estimate showing the equilibrium real interest rate at 2 percent. Even so, they only expect the nominal interest rate to peak in this cycle at 3.25 percent, according to the median.

“The Fed has spent this entire year telling us they are data dependent,” said Rajeev Dhawan, director of the economic forecasting center at Georgia State University in Atlanta. “And the second thing they are telling us is the natural rate of interest is lower. These two things are being digested.”

For Dhawan, “gradual” means the Fed will raise the benchmark rate a second time in March and then do nothing until December after the U.S. presidential election. He sees the next round of rate hikes bringing the policy rate to 2 percent by the end of 2017.

Another component of Yellen's gradual tightening strategy is about when they will begin reducing the size of their $4.5 trillion balance sheet. Some 62 percent of economists in the survey said that won't happen until 2017 or later.

Economists also had disparate views of inflation. Some 62 percent don't expect the Fed's preferred inflation index, the personal consumption expenditures price index, or PCE, to achieve a third consecutive month of 2 percent or higher readings until 2017 or later.

With the unemployment rate at 5 percent in November, just above the Fed's 4.9 percent definition of full employment, inflation performance could be the central theme driving the rate-hike pace.

Michael Pond, head of global inflation strategy at Barclays Capital Inc. in New York, said that the PCE's lower weighting for shelter and different measurement of medical costs versus the consumer price index, and “continued weakness in core goods prices” means the index won't start hitting the 2 percent mark until the third quarter of 2017.

That underwrites the firm's gradual pace estimates on interest rates. Barclays forecasts the benchmark lending rate will be in a range of 1 percent to 1.25 percent at the end of 2016, and a range of 1.75 percent to 2 percent at the end 2017, or zero in inflation-adjusted terms.

“We expect the Fed to be gradual in raising interest rates because inflation pressures and expectations are low and there is considerable uncertainty around the level of the neutral real fed funds rate,” Pond said.

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