Interest rate uncertainty has reached levels not seen since the financial crisis, posing significant challenges and opportunities for wealth advisors and RIAs. The Federal Reserve's future moves have become the subject of intense speculation on Wall Street, as financial professionals scramble to understand what lies ahead.
Recently, the Federal Reserve Bank of Kansas City introduced a new tool to measure this uncertainty: the Measure of Policy Rate Uncertainty (KC PRU). This index, which uses options pricing, quantifies the extent of uncertainty surrounding interest rates—a critical piece of information for advisors looking to guide their clients through these volatile times.
According to the KC PRU, markets are currently pricing in a 1.25 percentage-point range of possible outcomes for the federal-funds rate over the next year. While this is less uncertainty than we saw a year ago, it remains elevated compared to historical norms, especially outside of crisis periods. This reflects the many potential economic scenarios that could unfold, making it essential for wealth advisors to remain flexible in their investment strategies.
The methodology behind the KC PRU is similar to that of the Cboe Volatility Index (VIX), a widely-followed measure of stock market volatility. The KC PRU calculates uncertainty based on the prices of options that settle on short-term interest rates, which are closely tied to the federal-funds rate. This daily index highlights how quickly policy expectations can change in response to economic data releases or speeches by Federal Reserve officials.
The Kansas City Fed researchers also applied the index to historical data going back to 1989, showing that long-term trends generally point to decreasing policy uncertainty, except during periods of crisis like the Covid-19 pandemic and its aftermath.
For wealth advisors, the rise in policy uncertainty means increased volatility in financial markets, which can affect everything from bond yields to equity performance. The Federal Open Market Committee (FOMC) now operates with far greater transparency than in decades past, but that hasn’t eliminated uncertainty.
Gone are the days when analysts would try to gauge the Fed’s intentions by observing the thickness of then-chair Alan Greenspan’s briefcase. Today, policymakers publish detailed statements after each meeting, hold press conferences, and actively engage in public speeches to manage expectations. However, despite these efforts, uncertainty persists, especially as economic conditions fluctuate.
Starting in 2021, policy uncertainty surged as the U.S. economy rebounded from the pandemic, and inflation soared. The KC PRU hit a peak of 2.2 in early 2023, coinciding with the late stages of the Fed’s aggressive rate-hiking cycle and a series of regional banking crises that muddied the outlook further. As wealth advisors know, this kind of uncertainty can create both risks and opportunities. While the Fed paused rate hikes in July 2023 and began cutting rates by the end of the year, markets remain on edge about the pace and size of future reductions.
At present, the KC PRU is at levels last seen during the 2008-2009 global financial crisis. This compares to the much lower average levels seen between 2012 and 2020, when the index hovered around 0.49. The current reading suggests heightened market anxiety, even though it is down from the extreme highs of 2023. For context, the index hit a record low of 0.17 in late 2020, when the Fed was in full crisis mode, keeping interest rates near zero to support the post-pandemic recovery.
This rise in uncertainty reflects broader economic uncertainty as well. On the one hand, key economic indicators like unemployment and GDP growth remain strong, which could be seen as a positive for investors. On the other hand, inflation is still above the Fed’s target, the labor market is showing signs of softening, and a host of potential economic shocks—ranging from geopolitical tensions to supply chain disruptions—could derail growth. For wealth advisors, this means crafting strategies that can withstand a wide range of possible economic outcomes.
The uncertainty isn’t just about whether rates will rise or fall; it's about how fast and by how much. While the Fed has started cutting rates, the specifics of future reductions remain unclear. Fed Chair Jerome Powell has emphasized a data-driven, meeting-by-meeting approach, leaving markets to guess what comes next. This creates a difficult environment for advisors managing client expectations around fixed-income and equity investments.
Mary Daly, President of the Federal Reserve Bank of San Francisco, recently acknowledged this ambiguity, stating, “We’re at a place where reasonable people can disagree on the tactics, even if they agree on the strategy.” For wealth advisors, this means balancing near-term market moves with long-term goals, ensuring that clients’ portfolios are positioned to benefit from both rate cuts and potential economic slowdowns.
The Fed’s long-term goal is to return interest rates to a "neutral" level, where they neither boost nor restrain economic growth. Many economists believe this neutral rate sits around 3%, compared to the current fed-funds rate range of 4.75% to 5.0%. The median forecast from the FOMC’s September 2023 projections suggests about one percentage point of rate cuts over the next year, with another point of cuts by the end of 2025. This would bring the rate into a range of 3.25% to 3.5%, close to what many see as neutral.
For wealth advisors, understanding the implications of this forecast is critical. As rates come down, fixed-income investments may become more attractive, but the pace of rate cuts will determine how quickly this transition occurs. Additionally, the uncertainty surrounding the neutral rate itself—some FOMC members have forecasts that differ by more than a percentage point—adds another layer of complexity. Advisors must be prepared to pivot strategies as new economic data emerges.
It’s important to recognize that markets aren’t the only ones uncertain about the future. Even the Fed itself is navigating an unprecedented economic landscape. Policymakers are dealing with conflicting signals: while inflation has cooled from its 2022 highs, it remains above target, and the labor market, while strong, is showing signs of softening. For wealth advisors, these dynamics will require a careful balance of risk and reward in client portfolios.
In conclusion, the KC PRU highlights the elevated levels of interest rate uncertainty that wealth advisors and RIAs must contend with today. The path forward for interest rates is far from clear, and the economic environment is fraught with potential shocks.
As the Fed continues to adjust its policy based on incoming data, wealth advisors must remain agile, ready to adjust strategies as conditions change. In a world where uncertainty is the new normal, advisors who can stay informed and anticipate shifts will be best positioned to guide their clients through this challenging period.
