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Bearish Correction Still In Play

--Longer Run Fed Funds Rate Drops to All-Time Low of 2.75% 
--Signals Downgrade of Economy's Longer Run Potential 
--Fed Could Be More Cautious on Rate Hikes
By Jean Yung
     WASHINGTON (MNI) - Markets might have missed a dovish message out of the
Federal Open Market Committee this week amid a rush to price in a December
interest rate hike. Even as officials reaffirmed their view for a full
percentage point increase in the fed funds rate by end-2018, they downgraded
their estimate of the longer run neutral interest rate, signaling that rates
might have less room to rise than previously thought. 
     A lower neutral rate also means policymakers are more likely to be stuck at
the zero lower bound and forced to deploy nontraditional tools like asset
purchases if needed. That suggests extra caution is warranted ahead of future
rate hikes, especially if inflation continues to disappoint. 
     That sentiment may have been lost as markets focused on the fact that the
FOMC's characterization of where the economy and rates are headed in the near
term came more hawkish than anticipated. 
     The FOMC's latest forecast for its benchmark interest rate over the longer
run fell a quarter point to an all-time low of 2.75%. That means effectively
there is less room for policymakers to maneuver before the fed funds rate is no
longer stimulating the economy. And if inflation remains below target, the
ceiling on the Fed is also lower. 
     Federal Reserve Chair Yellen said in her press conference Wednesday that
the downward revision reflects "in some sense, a view that going out many years,
aggregate demand globally is likely to be weakened by continuing low
productivity growth and aging populations."
     That's a theme that has dogged the Fed since the financial crisis. The
so-called neutral rate, the interest rate that neither stimulates nor curbs
economic growth, has fallen steadily since 2012, when the FOMC first began
publishing their estimates. At the time, officials put it at 4.25%, already much
lower than its level in previous decades. 
     Over the past several years, policymakers have said persistent factors are
holding down the rate but that it should eventually rise as the economy recovers
from the financial crisis. But that has yet to materialize in FOMC forecasts. 
     Markets, by contrast, have projected a shallower rate path than the FOMC.
Despite the Fed's forecast of four more hikes between now and December 2018,
futures markets Thursday are still only pricing in a little over two rate hikes
over that same time horizon, according to the CME Group. 
     "Market participants may have lower estimates or believe that a low neutral
rate may be more persistent," Yellen acknowledged in her press conference. 
     For now the Fed has moved closer to the market's view. Whereas eight FOMC
members had estimated the neutral rate at 3.0% in June, only five now hold that
view. Nine members see a lower neutral rate, including four who put it at 2.75%,
the new median. 
     "FOMC participants, in light of incoming data, are adjusting their views,"
Yellen said, adding "I would say they still believe that in real terms, that
neutral rate will be rising somewhat over the next few years." 
     The FOMC said Wednesday they expect to raise the current target range for
the fed funds rate from 1.00% to 1.25% a full percentage point by the end of
2018 as the economy expands at a rate faster than its potential.  
     But faced with a shortfall in inflation, policymakers might be wondering if
the economy will need higher rates to contain those pressures. 
     Yellen hinted Wednesday that the FOMC will be looking very carefully at
each interest rate move as long as inflation data continues to disappoint.  
     "We have to balance various risks," she said. "One risk is that if we
tighten policy too quickly, we may find out that -- although we don't think this
now -- that the inflation shortfall is something that's going to be persistent."
     "If we tighten too quickly, we could undermine inflation performance, leave
it at too low levels," she continued. "Inflation expectations could fall and
that could become ingrained and that could be dangerous." 
     "So that's a reason to be cautious about raising interest rates when
inflation is as low as it is," she said. 
--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com
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