The terminal rate will be lower than in the past but very likely higher than current market expectations The neutral rate has fallen since the crisis — but the rate implied by market pricing is consistent with a very pessimistic scenario Neutral rate estimates 3-3.25% 2.00% Market pricing DB Neutral rate estimates are consistent with: Potential growth Productive -ty growth Source: C60. Laubach and Williams (2004 POMO. Deutsche Bank Research Fed Pre-crisis* 0.6% 0% 1.75-2% 1.25% 2-2.25% 1.5% 4.50% 3% 2% No (1 Avg. 1995-2005 Several of the reasons for a lower terminal rate have faded Fiscal policy Private deleveraging Mortgage credit conditions Subdued global growth Low potential growth Reducing Rationale terminal rate? • • • O O Deutsche Bank Research • Fiscal policy has shifted from a significant drag to neutral • Deleveraging slowed significantly: credit growth picking up • Still tight but showing some signs of loosening • Global growth, giving less external impulse to US growth • Still low but should rise modestly as productivity picks up Kiattetrihre.,="olt • How high the Fed's policy rate eventually rises (i.e., the terminal rate) is closely tied to the neutral rate - A higher neutral rate means the Fed has to raise rates more to tighten financial conditions ■ Estimates suggest the neutral rate is currently very low due to growth headwinds (e.g., fiscal drag, tight credit, slow global growth), lower potential growth ■ Neutral rate should rise as these headwinds fade and potential growth improves... • ...But estimates suggest that the long-run neutral rate will remain lower than in the past - Prior to the crisis the neutral rate was near 4.5% - Fed's estimate is currently 3.25-3.50%; we think it is somewhat lower (i.e., 3-3.25%) • The market pricing of a terminal rate around 2% is consistent with a very pessimistic economic scenario, assuming no rebound in potential growth • As the market reprices the pace of hikes, it will also have to raise its view on the terminal rate 12 Note (e): FOMC committee's leadership (Yellen. Fischer and Dudley) kke1f expect only 3-4 hikes CONFIDENTIAL - PURSUANT TO FED. R. GRIM. P. 6(e) CONFIDENTIAL DB-SDNY-0119259 SDNY_GM_00265443 EFTA01459048