Sunday, December 7, 2014

Most Households Expect Interest Rates to Increase by May

Two new posts on the New York Federal Reserve's Liberty Street Economics Blog describe methods of inferring interest rate expectations from interest rate futures and forwards and from surveys conducted by the Trading Desk of the New York Fed. In a post at the Atlanta Fed's macroblog, "Does Forward Guidance Reach Main Street?," economists Mike BryanBrent Meyer, and Nicholas Parker, ask, "But what do we know about Main Street’s perspective on the fed funds rate? Do they even have an opinion on the subject?"

To broach this question, they use a special question on the Business Inflation Expectations (BIE) Survey. A panel of businesses in the Sixth District were asked to assign probabilities that the federal funds rate at the end of 2015 would fall into various ranges. The figure below compares the business survey responses to the FOMC's June projection. The similarity between businesspeoples' expectations and FOMC members' expectations for the fed funds rate is taken as an indication that forward guidance on the funds rate has reached Main Street.

What about the rest of Main Street-- the non-business-owners? We don't know too much about forward guidance and the average household. I looked at the Michigan Survey of Consumers for some indication of households' interest rate expectations. One year ago, in December 2013, 61% of respondents on the Michigan Survey said they expected interest rates to rise in the next twelve months. Only a third of consumers expected rates to stay approximately the same. According to the most recently-available edition of the survey, from May 2014, 63% of consumers expect rates to rise by May 2015.

The figure below shows the percent of consumers expecting interest rates to increase in the next twelve months in each survey since 2008. I use vertical lines to indicate several key dates. In December 2008, the federal funds rate target was reduced to 0 to 0.25%, marking the start of the zero lower bound period. Nearly half of consumers in 2009 and 2010 expected rates to rise over the next year. In August 2011, Fed officials began using calendar-based forward guidance when they announced that they would keep rates near zero until at least mid-2013. Date-based forward guidance continued until December 2012. Over this period, less than 40% of consumers expected rate increases.

In December 2012, the Fed adopted the Evans Rule, announcing that the fed funds rate would remain near zero until the unemployment rate fell to 6.5%. In December 2013, the Fed announced a modest reduction in the pace of its asset purchases, emphasizing that this "tapering" did not indicate imminent rate increases. The share of consumers expecting rate increases made a large jump from 55% in June 2013 to 68% in July 2013, and has remained in the high-50s to mid-60s since then.

But since 1978, the percent of consumers expecting an increase in interest rates has tracked reasonably closely with the realized change in the federal funds rate over the next twelve months (fed funds rate in month t+12 minus fed funds rate in month t). In the figure below, the correlation coefficient is 0.26. As a back-of-the-envelop calculation, if we regress the change in the federal funds rate in twelve months on the percent of consumers expecting a rate increase, the regression coefficients indicate that when 63% of consumers expect a rate increase, that predicts a 25 basis points rise in rates in the next year.

This survey data does not tell us for sure that forward guidance has reached Main Street. The survey does not specifically refer to the federal funds rate, just to interest rates in general. And households could simply have noticed that rates have been low for a long time and expect them to increase, even without hearing the Fed's forward guidance.  In an average month, 51% of consumers expect rates to rise over the next year, with a standard deviation of 15%. So the values we're seeing lately are about a standard deviation above the historical average, but they have been higher historically. In the third and fourth quarters of 1994, after the Fed had already begun tightening interest rates, 75-80% of consumers expected further rate increases. At the start of 1994, however, only half of consumers anticipated the rate increases that would come.

In May 2004, the FOMC noted that accommodation could “be removed at a pace that is likely to be measured.” That month, 85% of consumers (a historical maximum) correctly expected rates to increase.


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