Fed Ushers in a New Era of Uncertainty on Rates Investors are weighing when Federal Reserve will start raising interest rates, but where they end up in long run also is a crucial question By Jon Hilsenrath Updated March 1, 2015 8:17 p.m. ET , WSJ It’s clear Fed officials think they’ll be raising short-term interest rates later this year. Of greater significance – and getting far less attention – is how high rates will go. Investors these days are obsessing over when the Federal Reserve will start raising short-term interest rates. Drawing less scrutiny is where rates will end up in the long run and how they’ll get there. But it’s time to start paying attention. Fed officials have made clear they expect to begin raising short-term interest rates from near-zero this year, though not before midyear. After that, there is great uncertainty at the central bank and in the markets about the future path of interest rates. The long-run outlook for rates has consequences for everyone. For households, it will determine payments on mortgages and car loans; for businesses, on corporate bonds; and for the government, on the $13 trillion in debt held by the public. A disconnect between the Fed and the market over the long-run rate outlook also could be a source of market turbulence in the months ahead. Central-bank policy makers on average see rates going nearly twice as high as futures markets indicate in coming years, for a variety of reasons. If the Fed is wrong, it might make a mistake on interest rates that jars the economy. If the market is wrong, it might be setting itself up for a tumble if rates go higher than expected. The Fed’s latest forecasts show that nine of 17 policy makers see the central bank’s benchmark interest rate—the federal funds rate—at 1.13% or higher by year-end. The median estimates—meaning half are above and half below—reach 2.5% for the end of 2016 and 3.63% for the end of 2017. On the other hand, in fed funds futures markets, where traders buy and sell contracts based on expected rates, the expected fed funds rate is 0.50% on average in December 2015, 1.35% in December 2016 and 1.84% in December 2017. One reason for the disparity: Futures prices reflect investors’ calculations that there is some probability rates will return to near-zero after a few increases and stay there. This happened in Sweden after its central bank raised rates in 2010 and in Japan after 2006. In both cases, the central banks had to reverse course and cut rates after economic shocks and deflation pressures crippled their economies. A survey by the New York Fed of Wall Street bond dealers in January showed they attached a 20% probability to U.S. short-term rates returning to zero within two years after liftoff. A return to zero isn’t the Fed’s expected outcome, so it doesn’t show up in its rate forecasts. Fed Ushers in a New Era of Uncertainty on Rates Investors are weighing when Federal Reserve will ...

1. Fed Ushers in a New Era of Uncertainty on Rates
Investors are weighing when Federal Reserve will start raising
interest
rates, but where they end up in long run also is a crucial
question
By Jon Hilsenrath
Updated March 1, 2015 8:17 p.m. ET , WSJ
It’s clear Fed officials think they’ll be raising short-term
interest rates later this year. Of
greater significance – and getting far less attention – is how
high rates will go.
Investors these days are obsessing over when the Federal
Reserve will start raising short-term interest
rates. Drawing less scrutiny is where rates will end up in the
long run and how they’ll get there. But it’s
time to start paying attention.
Fed officials have made clear they expect to begin raising short-
term interest rates from near-zero this
year, though not before midyear. After that, there is great
uncertainty at the central bank and in the
markets about the future path of interest rates.
The long-run outlook for rates has consequences for everyone.
For households, it will determine
payments on mortgages and car loans; for businesses, on

2. corporate bonds; and for the government, on
the $13 trillion in debt held by the public. A disconnect between
the Fed and the market over the long-run
rate outlook also could be a source of market turbulence in the
months ahead.
Central-bank policy makers on average see rates going nearly
twice as high as futures markets indicate
in coming years, for a variety of reasons.
If the Fed is wrong, it might make a mistake on interest rates
that jars the economy. If the market is
wrong, it might be setting itself up for a tumble if rates go
higher than expected.
The Fed’s latest forecasts show that nine of 17 policy makers
see the central bank’s benchmark interest
rate—the federal funds rate—at 1.13% or higher by year-end.
The median estimates—meaning half are
above and half below—reach 2.5% for the end of 2016 and
3.63% for the end of 2017. On the other
hand, in fed funds futures markets, where traders buy and sell
contracts based on expected rates, the
expected fed funds rate is 0.50% on average in December 2015,
1.35% in December 2016 and 1.84% in
December 2017.
One reason for the disparity: Futures prices reflect investors’
calculations that there is some probability
rates will return to near-zero after a few increases and stay
there.
This happened in Sweden after its central bank raised rates in
2010 and in Japan after 2006. In both
cases, the central banks had to reverse course and cut rates after
economic shocks and deflation

3. pressures crippled their economies.
A survey by the New York Fed of Wall Street bond dealers in
January showed they attached a 20%
probability to U.S. short-term rates returning to zero within two
years after liftoff.
A return to zero isn’t the Fed’s expected outcome, so it doesn’t
show up in its rate forecasts.
Fed Ushers in a New Era of Uncertainty on Rates
Investors are weighing when Federal Reserve will start raising
interest
rates, but where they end up in long run also is a crucial
question
By Jon Hilsenrath
Updated March 1, 2015 8:17 p.m. ET , WSJ
Investors might have other doubts about the Fed—that it won’t
reach its 2% inflation target and will thus
be forced to keep rates low, or that it won’t have the will to
carry through on the rate increases it has
telegraphed.
The longer-run rate outlook was the center of discussion Friday
at a monetary-policy conference
sponsored by the University of Chicago Booth School of
Business. Fed Vice Chairman Stanley Fischer
said there that market expectations might move—perhaps
abruptly—closer to the Fed’s when the central

4. bank starts lifting rates. A first increase “will add to the
credibility of what we’re saying,” he said in a not-
so-subtle warning to investors who doubt the Fed’s plans.
In theory, there is a long-run equilibrium interest rate where the
Fed is headed which, as with Goldilocks
and her fabled porridge, would leave the economy neither too
hot nor too cold. That is, this rate is not so
low that it causes inflation to surge but not so high that it holds
back growth.
Federal Reserve Vice Chairman Stanley Fischer, shown in
October, on Friday said
market expectations might move—perhaps abruptly—closer to
the Fed’s when the central
bank starts lifting rates. PHOTO: ASSOCIATED PRESS
It is also the rate that balances investment and saving. In a
period when businesses are reluctant to
invest, or when savers are piling money away, the rate is likely
to be low.
Fed Ushers in a New Era of Uncertainty on Rates
Investors are weighing when Federal Reserve will start raising
interest
rates, but where they end up in long run also is a crucial
question
By Jon Hilsenrath
Updated March 1, 2015 8:17 p.m. ET , WSJ

5. Economists have been puzzling over this rate, also called the
natural rate, for more than a century. “The
natural rate is not fixed or unalterable,” Swedish economist
Knut Wicksell posited in a famous 1898 book
on interest. The problem, he noted, was that it depended on “a
thousand and one things which determine
the current economic position of a community; and with them it
constantly fluctuates.”
Fed officials estimate this long-run rate is now around 3.75%,
which amounts to 2 percentage points as
compensation for inflation and a 1.75-percentage-point real
return on investment. Their forecasts suggest
they effectively see themselves getting close to this equilibrium
rate by the end of 2017.
Lawrence Summers , Harvard University economics professor,
has posited that the equilibrium rate is
lower now than in the past because the economy is growing so
slowly and real returns have fallen. Fed
officials have nudged their estimate down from 4.25% in 2012.
Many investors have doubts about the Fed’s forecasts.
Meanwhile, many economists and Fed officials
don’t see eye to eye with Mr. Summers on his theory that a new
era of “secular stagnation” in the
economy has substantially lowered the equilibrium interest rate.
“We are skeptical of the secular stagnation view,” concluded a
paper presented at the Booth conference.
Like many Fed officials, the authors— James Hamilton of the
University of California, San Diego; Ethan
Harris of Bank of America ; Jan Hatzius of Goldman Sachs and
Kenneth West of the University of

6. Wisconsin—concluded the economy has been held back by
temporary headwinds and not a permanent
reduction in its potential growth rate.
Given all the uncertainties about growth and inflation, Fed
officials will have to feel around for the right
long-run interest rate like a person in the dark.
“I don’t think that is a question we can answer right now,” Mr.
Fischer said of the long-run rate.
The uncertainty means an important change in central-bank
tactics is coming. For a decade now, Fed
officials have used various ways to give investors “forward
guidance” about where interest rates are
going.
In their latest guidance, Fed officials said they would be
“patient” before starting to raise rates, meaning
no rate increase is likely at their next two policy meetings. They
are now moving away from this guidance.
It appears investors are going to find themselves doing a lot of
guesswork about the path of rates after
they start rising this year, along with the Fed itself.