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More Certainty Over The Direction Of Interest Rates?

January 27, 2012

Following the January 25th meeting, the Fed released a forward-looking rate forecast.  This forecast shows the range of predictions made by Fed officials about the level of short-term interest rates in the fourth quarter of 2012, 2013 and 2014.  The forecast also estimates when the Fed expects to begin raising short-term rates, and describes what the Fed plans to do with their investment portfolio.

The rationale for this change in policy is to provide more clarity for businesses and consumers as to the direction and level of short-term rates.  The hope is that it will spur additional borrowing and economic growth (though it is possible this will not have any material impact on businesses or consumers, as most already expect rates to remain low for a while).

However, this shift in policy raises several questions that decision-makers should consider:

  • How might other financial institutions respond? Now that the Fed announced rates are likely to remain low into 2014, do financial institutions further adjust loan pricing—dropping rates even further?
  • Will financial institutions take additional risk in their loan and investment portfolios by extending maturities?
  • Will there be additional market demand for short- and medium-term investments, further driving down yields?
  • Does this push decisions to “hedge” balance sheet risk further down the road, at which time hedging could become too expensive?
  • Why is the “risk management” function in place? To inform decision-makers about how the institution could fare in the face of unlikely events.  Institutions that put too much reliance on Fed forecasts might spend less time preparing for the unexpected
  • Is the Fed always right? Consider Fed Chairmen Ben Bernanke’s quote from his July 2007 testimony to Congress when he said, “Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.”  Unfortunately, the economy worsened materially in 2008

The Fed is a group of people, each with their own opinions.  They also do not have total control over all of the factors that would impact the level of rates.  Therefore, the Fed forecasts could be wrong.  However, the forecasts might lead to overconfidence, causing institutions to make decisions they might not have made otherwise.

Sources:
Fed Expects Low Rates Through 2014, WSJ, 1/26/12
Semi-Annual Monetary Report to the Congress, Federal Reserve Board, 7/18/07

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