Money Perspectives With Dr. Larry ‘Chip’ Filer
Dr. Larry “Chip” Filer is an associate professor of economics at the Strome College of Business at Old Dominion University in Norfolk, Virginia. His specialties include banking and Federal Reserve policy. Read what Dr. Filer expects from interest rates in 2015 in this email interview with MoneyRates.
MoneyRates: Interest rates have been more or less on the decline for decades. What factors, other than rising inflation, could cause a turnaround in the long-term direction of rates?
Dr. Filer: The answer is, essentially, nothing. Since the Volker disinflation, the Federal Reserve has flexed its inflation-fighting muscles on many an occasion. That has built up a tremendous amount of credibility by the Fed and has served to create a low and stable interest rate environment across all maturities. There is no better example of that than the current environment, where we have low inflation and historically large amounts of liquidity. The only way I see interest rates rising above the average of the past two decades or so is if the market loses faith in the Fed and anticipates substantively higher rates of inflation. I just can’t envision any event that could precipitate that outcome.
When the Fed finally chooses to lift the federal funds rate, how quickly do you expect it to rise? What factors may affect this?
This is a tough question. I think the safe bet is that they raise the funds target in rather small increments at the start. This would be a natural hedge against overshooting. However, they could raise rates at a faster pace if they believe that the markets could handle a pause during the tightening. That is the unknown. If markets would become jittery if the Fed paused at some point during the normalization process, it is in the Fed’s best interest to do smaller and more consistent hikes over a long period.
When the federal funds rate finally rises, how long will it take for short-term consumer interest rates – such as those on savings accounts – to follow it?
This provides a nice way to follow up on some of my comments in the previous question. With monetary policy so accommodative, the fed funds target rate is far less of a true measure of policy accommodation. When we experience rates at the zero lower bound (ZLB), the true accommodative stance of Fed policy is unknown. Cynthia Wu and Fan Dora Xia published an important paper on this last year which attempted to measure what they call the “shadow funds rate.” In other words, what is the fed funds rate (under existing policy) if the fed funds target could be less than zero? This is a recognition that the size of the Fed’s balance sheet matters. For December of 2014, the shadow rate was -2.42 percent. This is over 200 basis points from the target rate. What this means is that even as the funds rate begins to rise, the amount of policy accommodation will still remain high, imparting pressure on short-term rates. While we are forecasting in increase in short-term interest rates for 2015, they are very small — only on the order of 5 to 7 basis points. This is going to be a very long process before consumer rates start to respond in any magnitude.
Do you believe that marginally higher interest rates would cause a significant drag on the economy if they appeared today? How about the stock market?
Currently, the team here at ODU is projecting the first fed funds target rate hike in October of 2015. That is slightly later than our previous expectation of the first hike occurring at the September meeting. That is largely because of the uncertainty with Europe. Some other private sector forecasts have pushed the first hike into 2016. We just don’t see any possibility of movement by the Fed in the early part of this year. It would be too much of a drag. Worth noting is the late 2014 flattening of the yield curve. Markets typically loathe flat yield curves. With long rates dropping during 2014, that gives the Fed much fewer options for raising rates at the short end. Economic growth should help alleviate this problem, so I am sure the Fed is hoping to see long-term rates rise as the U.S. economy grows in 2015.
