“Don’t fight the Fed” was good advice for anyone tempted to test Paul Volcker’s resolve in taming inflation but it hasn’t worked out so well for those who placed their faith in the US Federal Reserve’s sanguine forecasts of recovery and rising interest rates since the crisis.

Instead, traders have profited by betting against officials’ optimistic projections while the Fed now thinks the markets were right all along.

There are still disagreements about the next few years — Fed officials expect to raise their target interest rate band by 1.25 percentage points between now and the end of 2018, something futures markets imply has almost no chance of happening — but central bankers now think the markets were right all along about the long-term outlook.

The Fed’s Open Market Committee first published its estimate of the “longer run” level of its policy interest rate on January 25 2012. Back then, the median estimate of policymakers was for short-term interest rates to average around 4.25 per cent over the course of a normal business cycle. Subtracting the Fed’s inflation expectation of 2 per cent, the implied forecast for real short-term interest rates was about 2.25 per cent — consistent with the experience of the Greenspan era.

Fixed income markets implied this wasn’t realistic at the time. With the brief exceptions of the “taper tantrum” of mid-2013 and the deflation scare of early 2016, bond and derivative prices implied the real policy rate would average about 1 per cent over the course of a normal business cycle. The central bank eventually adopted this view last summer. The fight ended because the bond traders won.

Start by looking at the prices of Eurodollar futures contracts. These let traders bet on the level of the three-month London Interbank Offer Rate up to 10 years in the future. To turn these prices into estimates of Fed policy, you need to adjust for the relative illiquidity of the distant contracts and the fact that Libor as a money market rate tends to trade slightly above the Fed’s policy target.

During the era of a published Fed “longer run” forecast of its target interest rate, distant Eurodollar contracts have consistently implied the policy rate would average somewhere between 2 and 3 per cent. That’s close to, but below, the Fed’s current forecast.

The modest difference can probably be explained by differences in the inflation outlook of traders and central bankers, rather than differences in the outlook for real interest rates.

Since the start of 2012, the average annual inflation rate in the Fed’s preferred measure of prices has been 1.2 per cent. Even excluding food and energy prices, which fell over the period, inflation averaged only 1.5 per cent, compared with the Fed’s “longer run goal” of 2 per cent. If traders have been using recent experience to inform their expectations of future inflation and their interpretations of the central bank’s inflation goal, the real short-term interest rate forecast implied by Eurodollar futures would be identical to the Fed’s current projections.

Treasury Inflation-Protected Securities tell a similar story. Since January 2012, yields on Tips have consistently implied real short-term interest rates would average around 1 per cent once the economy had returned to normal.

One way to see this is to break up the 30-year inflation-indexed bond into a 10-year note plus a 20-year bond that starts 10 years from now. Focusing on forward interest rates helps smooth the noise from a business cycle dragging long-term bond yields above or below the implied normal level of short-term interest rates.

Currently you end up with a market-implied forecast from Tips that real short-term interest rates will average around 1 per cent after the economy returns to normal, matching both the Fed’s forecast and the forecast implied by Eurodollar futures.

America’s central bankers long believed the crisis was a painful but temporary blip. After years of disagreement, bond traders eventually succeeded in persuading the policymakers that normalcy would never return.

They fought the Fed and the Fed capitulated. Yet despite this experience, officials continue to be significantly more optimistic than the markets about the pace of rate hikes over the next few years — just as they have been ever since the recession ended. That seems unwise.


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