FYI | Jun 25 2009
By Chris Shaw
In recent weeks the market has become increasingly concerned the emergence of economic “green shoots” makes it more likely the US Federal Reserve would need to lift interest rates, but according to Westpac’s assessment such a conclusion is not what the fundamentals are indicating.
Senior economist Justin Smirk points out the bank’s model for estimating the Fed Funds rate has a reasonable track record in estimating the actual fund rate, meaning it is useful for predicting what action the Fed may take with respect to rates relative to the state of both the US and global economies.
The bank’s model makes use of fundamental variables including core PCE (personal consumption expenditure), non-farm payrolls, unemployment expectations and the share market, while ignoring Fed Funds rate lags and market pricing. At present the bank is forecasting economic growth to contract by almost 3% this year before delivering modest growth of 1.2% in 2010, while it expects unemployment will peak at a little more than 11% late next year.
Core PCE inflation is forecast to moderate to 1% by the middle of 2010, while the bank expects equities will deliver only modest price gains over the next 12 months or so. Using such assumptions the model suggests the Fed Funds rate will bottom at minus 2% in mid-2010, but Smirk points out as a negative rate is impossible, it highlights the magnitude of the quantitative easing required to offset current conditions.
Given the model’s prediction Smirk takes the view any change in monetary policy by the Fed will be a 2-step process, with the first being the removal of quantitative easing and the second increases in official interest rates. Assuming it is over the course of 2010 that quantitative easing is undone it implies rates are unlikely to move higher until the second half of 2011 at the earliest.
