by Calculated Risk on 12/08/2009 01:47:00 PM

In a research note titled: "The Fed Will Exit in 2010", Morgan Stanley's Richard Berner and David Greenlaw forecast that the Fed will raise the Fed Funds rate in the 2nd half of 2010 to 1.5%.

They are forecasting GDP to increase 2.8% in both 2010 and 2011, and for unemployment to peak in Q1 2010 at 10.3%, and decline to 9.5% in 2011.

The GDP and unemployment rate forecasts are consistent with each other (see my post: Employment and Real GDP), but the real question is why do they expect the Fed to raise rates in the 2nd half of 2010 with a sluggish recovery?

The reason is they expect inflation expectations to pickup, and the Fed to react by raising rates (to 1.5% by the end of 2010, and 2.0% by the end of 2011). That would be unusually since the Fed historically waits until sometime well after the unemployment rate peaks.

The following graph is from I post I wrote in September: Fed Funds and Unemployment Rate

Click on graph for larger image in new window.

This graph shows the effective Fed Funds rate (Source: Federal Reserve) and the unemployment rate (source: BLS)

In the early '90s, the Fed waited more than a 1 1/2 years after the unemployment rate peaked before raising rates. The unemployment rate had fallen from 7.8% to 6.6% before the Fed raised rates.

Following the peak unemployment rate in 2003 of 6.3%, the Fed waited a year to raise rates. The unemployment rate had fallen to 5.6% in June 2004 before the Fed raised rates.

Here is more from Paul Krugman: When should the Fed raise rates? (even more wonkish)

Goldman Sachs recently forecast that the Fed will be on hold through 2011:

The key features of our 2011 outlook: (1) a strengthening in growth from 2.1% on average in 2010 to 2.4% in 2011, with real GDP rising at an above-potential 3½% pace in late 2011; (2) a peaking in unemployment in mid-2011 at about 10¾%; (3) extremely low inflation – close to zero on a core basis during 2011; and (4) a continuation of the Fed’s (near) zero interest rate policy (ZIRP) throughout 2011.

Although there are other considerations - such as inflation expectations, I don't expect the Fed to raise rates until late in 2010 at the earliest - and more likely sometime in 2011 or even later.