The historical record
Relying on work dating tightening cycles by Federal Reserve staff, the analysis focuses on the six episodes since 1980. While the first five episodes evolved in broadly similar ways, the sixth tightening cycle, which started in December 2015 and was the first after the Global Financial Crisis (GFC), was much slower but also longer than the earlier five. This is not surprising: since the GFC was centred on the financial system the Fed naturally decided to proceed cautiously.
The table shows the month of the first interest rate increase, the number of months the episode lasted, the total increase in interest rates and the average increase in rates per month. The first four episodes lasted between 12 to 18 months. The episode that started in 2004 was a little longer, lasting 25 months. The longest was the post-GFC episode that lasted more than three years.
Investment Insights
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How fast will the FOMC raise interest rates?
With CPI inflation in the US exceeding 8% year-on-year in March and with interest rates at 0.25%-0.5% the Federal Reserve is in a tightening mode, having first hiked rates by 25bps on 16 March. But how fast might it raise interest rates from here? To address this question, it is useful to review how the Fed has behaved in past tightening episodes.
Table 1. Average dots and fitted curves
The table shows that these tightening cycles involved a cumulative increase in interest rates of between 1.75% and 4.25%. Interestingly, the long post-GFC episode entailed a relatively small cumulative increase of 2.25%.
Another way to compare these episodes is to look at the 'speed' of tightening, defined as the cumulative increase in interest rates divided by the length of the episode. The episodes have been broadly similar, with an average speed of tightening of 15 – 23bps per month. The exception is the post-GFC episode with an average speed of 6bps per month.
As a rule of thumb, and disregarding the 2015 episode, the historical evidence suggests that tightening episodes last about 15 months and involve around a 3% cumulative increase in interest rates, implying a speed in the order of 20bps per month.
What do FOMC members, and the markets, expect this time?
Next, we turn to the question of how FOMC members and market participants think this episode of interest rate tightening will evolve. Plotting a path assuming a monthly increase of 17.3bps, which is the average monthly increase for the episodes reviewed above (disregarding the post-GFC tightening cycle), starting from March 2022 onward, the path implies an interest rate of 1.855% in December.
Interestingly, the median dot for December 2022 in the FOMC’s 'dot plot' published in March 2022 is for an interest rate of 1.875%. Thus, the FOMC expects to raise interest rates in a manner compatible with the historical record. Furthermore, the median FOMC member expects interest rates to peak at 2.75% at the end of 2023, which matches very well the historical record of tightening cycles involving about a 3% increase in interest rates in total.
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