The end of the zero rate policy


With monetary policy, what matters most is the destination, not the journey. What ultimately shapes the economy and the markets is not the tactical maneuvers of a central bank, but How many he ends up raising interest rates.

Driving the news: Now, a seismic shift is underway in the outlook for the so-called terminal rate of this tightening cycle.

  • Since Tuesday’s high inflation reading, expectations have risen that the Fed will eventually climb much higher than it seemed likely a week ago. This drives down stock prices and increases the chances of a recession.

Why is this important: If the outlook quickly priced into the markets becomes a reality, it marks the end of an era when rates seemed to be perpetually stuck at zero.

  • Maybe the ZIRP (zero interest rate policy) is no more. That, at least, is now priced into the bond market, with one-year Treasuries now yielding over 4%, the highest since 2007.

By the numbers: On September 9, for example, futures markets estimated the probability that the Fed’s target rate would be above 4.5% by February at less than 1%. By Friday morning, those odds had risen to 36%, according to CME group calculations.

  • Mechanically, higher interest rates make every dollar of future income worth less today. This helps explain why the S&P 500 is down 7% since Monday’s close (as of 10 a.m. EDT Friday).

The dominant view is that the Fed’s target rate will hit the ballpark of 4% by the end of this year. This rate is currently slightly below 2.5%. Some commentators now see a rate target close to 5%, or something close, as likely.

What they say : Deutsche Bank economists analyzed the potential endpoint of the Fed’s target rate using a few different approaches and found that they “all suggest that a federal funds rate at or around 4.5% could be required early next year”.

  • But US Chief Economist Matthew Luzzetti and three colleagues argued in a research note published yesterday that, “given risk management considerations, a rate close to 5% is likely necessary.”

This seemingly small difference has massive implications for financial assets.

  • Ray Dalio, the founder of the massive Bridgewater hedge fund, argued in a LinkedIn post that if the Fed ends up pushing rates to 4.5%, it implies a 20% decline in stock prices due to the higher discount rate for future earnings, as well as lower incomes.

And after: Following its policy meeting which will end on September 21, Fed officials will issue new forecasts regarding, among other things, their own expectations for the course of interest rates.

  • In June, the median civil servant thought rates would reach 3.8% at the end of next year; on Wednesday we find out if they have revised those forecasts up.

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