May 18, 2023
Expectations for the Federal Reserve’s target for the federal funds rate—the central bank’s key interest rate target—have diverged for months. On one side is the Fed itself, which issues a quarterly summary of the projections of individual Fed policymakers. On the other are “the markets,” with their expectations often gauged by the prices of derivatives (federal funds futures) traded on the Chicago Mercantile Exchange.
In mid-March, the last time the Fed issued rate projections, policymakers foresaw no rate cuts by year-end. Futures pricing suggested a starkly different view in the markets—a bit more than 70 basis points (0.70 percentage points) of rate cuts by year-end. By mid-May, futures prices had changed modestly, implying about 60 basis points of rate cuts.
Yet “the Fed’s views and those of the market may not be as far off as they appear,” said Rhea Thomas, a Vanguard economist.
The Federal Reserve Bank of New York conducts surveys of both primary dealers—firms authorized to trade government securities directly with the Fed—and market participants. Those surveys should largely reflect the views of key market actors. And in mid-March they were much more closely aligned with the Fed’s own projections, looking for the rate target to end the year close to its peak. (Vanguard participates in the New York Fed survey of market participants.)
Notes: Although the Federal Reserve doesn’t publish official expectations for the federal funds rate target, it does publish the median of policy-setting committee members’ individual projections quarterly in the Summary of Economic Projections. The most recent published results available for the New York Fed surveys were for those conducted March 8–14, 2023.
Sources: Vanguard calculations, using data from the Federal Open Market Committee, the Federal Reserve Bank of New York, and Bloomberg. Fed survey data are through March 14, 2023, the end date of the New York Fed’s most recent surveys of primary dealers and market participants. Futures-based market expectations are based on federal funds rate futures pricing as of the same date. Fed Summary of Economic Projections data are through the most recent projections, on March 22, 2023.
Why the difference between survey-based market expectations and those based on futures prices? One key reason is that survey-based expectations reflect the modal, or most likely, expected outcome. In contrast, futures-based pricing incorporates the average expectation across the distribution of all probabilities—including outliers that may distort the average—along with a risk premium. As a result, survey-based expectations may provide a clearer picture of where markets ultimately expect the federal funds rate target to land.
Vanguard’s own view is that the Fed won’t cut its key rate target before 2024 because of its need to keep policy sufficiently restrictive to bring inflation back toward its 2% target.
The views below are those of the global economics and markets team of Vanguard Investment Strategy Group as of May 17, 2023.
Our 10-year annualized nominal return and volatility forecasts are shown below. They are based on the March 31, 2023, running of the Vanguard Capital Markets Model® (VCMM). Equity returns reflect a 2-point range around the 50th percentile of the distribution of probable outcomes. Fixed income returns reflect a 1-point range around the 50th percentile. More extreme returns are possible.
Notes: These probabilistic return assumptions depend on current market conditions and, as such, may change over time.
Source: Vanguard Investment Strategy Group.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of March 31, 2023. Results from the model may vary with each use and over time. For more information, see the Notes section.
With inflation still too high and the labor market still tight, we expect Federal Reserve policymakers to raise their target for short-term interest rates once more next month. In a change to our forecast, we expect that hike to be the last in a series that so far spans 10 meetings and 5 percentage points. We now see the Fed’s terminal rate in a range of 5.25%–5.5%, just a quarter of a percentage point higher than the current rate target. We also have raised our year-end inflation forecast and modified our labor market forecast.
A 4.5% first-quarter increase in GDP compared with a year earlier, powered by consumers tapping their savings after COVID-19-related lockdowns in 2022, may well represent peak 2023 economic activity in China.
Although strong tourism and hospitality data from the May Labor Day holidays show pent-up demand carrying into the second quarter, four recent developments cast doubt on the sustainability of the recovery:
“As the reopening surge fades and external demand deteriorates, further growth recovery in China hinges on continued labor market and income recovery, improving private confidence, and continued policy support,” said Grant Feng, a Vanguard economist. We foresee full-year GDP growth in a range of 6%–6.5%, higher than the government’s official 2023 growth target of “around 5%” but decelerating toward trend in coming quarters.
Unlike that of the Federal Reserve a day earlier, the European Central Bank’s (ECB’s) monetary policy stance, as articulated on May 4, was unequivocal: Interest rates are not sufficiently restrictive to tame inflation. The ECB raised its deposit facility rate by 25 basis points to 3.25%. Although the seventh consecutive hike marked a slowing in the rate of increases after three successive 50-point hikes, President Christine Lagarde made clear in her post-announcement news conference that the rate-hiking cycle isn’t over.
Inflation, the labor market, and overall economic activity have been stronger than expected, leading us to increase our forecasts for GDP growth, inflation, and the Bank of England (BOE) terminal rate.
“We continue to anticipate a recession later this year, though shallower than we had previously thought,” said Roxane Spitznagel, a Vanguard economist. “Recent developments increase the risk, however, of a ‘later landing’—a deeper recession, delayed into 2024, with higher-than-anticipated interest rates required to counter stickier inflation.”
Our growth upgrade for China and resilient activity globally have led us to increase our forecast for 2023 emerging markets GDP growth from 3.25% to 3.9%. “Emerging market manufacturing indexes are holding up well, and so are softer indicators such as business and consumer sentiment,” said Vytas Maciulis, a Vanguard economist. “Even emerging Europe, where the inflation challenges are greatest, is contributing to the improved sentiment.”
The Bank of Canada wrestled at its April 12 policy meeting with a choice of raising its interest rate target or keeping it steady for a second consecutive month, meeting minutes show. In the end, the Governing Council voted to keep its rate target at 4.5% to give itself “the opportunity to accumulate more evidence that a higher policy rate is in fact required.”
Among the rationales for raising the rate target was the idea that—although the pace of inflation has edged down—getting from 3% inflation to the bank’s 2% target was likely to be the hardest increment. The Governing Council considered that a further rate hike might be deemed necessary.
“High core and services inflation can eventually show up in higher wages,” said Asawari Sathe, a Vanguard senior economist. “The Bank of Canada is worried about such sticky inflation. With the labor market as strong as it is, we believe monetary policy may have to tighten further.”
We continue to foresee 2023 GDP growth of about 1%, with risks to the downside, and a recession late in the year.
The pause in the Reserve Bank of Australia’s (RBA’s) rate-hiking cycle was short-lived. Having interrupted a string of 10 consecutive hikes at its April meeting to “assess the state of the economy and the outlook,” the RBA raised its cash rate by 25 basis points this month. The rate, now 3.85%, is at an 11-year high. In its statement, the bank said that although inflation had passed its peak, it is “still too high and it will be some time yet before it is back in the target range.”
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IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.