The Federal Reserve (Fed) is widely expected to hike rates for the second time in 2018 at the conclusion of its two-day policy meeting on Wednesday, June 13. Given that the hike is all but priced in, the hike itself would mean little to markets. Instead, Fed watchers will be looking at any meaningful changes in the policy statement, a new set of economic projections, and Chair Jay Powell’s post-meeting press conference to gauge any changes to the future path of interest rates. There’s a reasonable chance that the median expectation for the number of rate hikes in 2018 in the new projections may shift from three to four, but we believe it’s more important to monitor any changes in the Fed’s inflation views to determine the likelihood that the Fed may shift to a more aggressive path of rate hikes. Unless we see a shift in the Fed’s view of inflation, we will continue to maintain a base case of three total rate hikes in 2018.
GROWTH FORECASTS LEAVING INFLATION BEHIND, FOR NOW
Every second Fed meeting is accompanied by a set of economic projections, made individually by the 7 members of the Fed Board of Governors and the 12 regional Federal Reserve Bank presidents. Over the last several sets of projections, 2018 growth forecasts have climbed meaningfully, while inflation forecasts have remained stable [Figure 1]. For the Fed, this is a “Goldilocks” economy, in which we have solid economic growth but inflation remains contained, allowing the Fed to move gradually toward a more neutral policy stance while still fulfilling its dual mandate of maintaining maximum sustainable employment and low and stable inflation.
As of the last set of projections, made in March, median expectations for growth in 2018 (+2.7%), 2019 (+2.4%), and 2020 (+2.0%) were all above the longer-run growth rate of 1.8%. Similarly, expectations for the unemployment rate in 2018 (3.8%), 2019 (3.6%), and 2020 (3.6%) were well below the expected longer-run rate of 4.5%. Clearly, the economy is at or above maximum sustainable employment and the Fed has no more work to do here. However, the Fed believes it has had leeway to tighten policy gradually, avoiding a shock to the economy, due to inflation expectations for 2018 (1.9%), 2019 (2.0%), and 2020 (2.1%) that remain in line with longer-run expectations (2.0%).
Since the economy is meeting the goal of maximum sustainable employment, the key to Fed policy is now inflation. As reflected in their inflation expectations, Fed members do not see meaningful inflationary pressures over the next several years. Several risk factors, however, need to be monitored, primarily the possibility that a tightening labor market could start to create additional wage pressures, in addition to the potential impact of trade policy. Neither of these is creating a meaningful shift in expectations to date, and even modest pressures would be manageable, allowing the economy to potentially stay in the Goldilocks zone for an extended period. But even if that is our base case, inflation risks lean to the upside. Market participants are aware of these risks and will be carefully watching for any signs that the Fed sees inflation risks increasing.
CONNECTING THE DOTS
One of the data points that gets the most attention is the median dot in the “dot plots,” the projections for expected interest rates at the end of 2018, 2019, and 2020 and in the longer run. There would usually be 19 dots, each representing an individual view, although transitions or turnover can temporarily lower the number. The March numbers, for example, had 15 individual projections. The median projection is just the individual forecast that’s in the middle. A simpler idea than an average, the median provides a more straightforward way of characterizing which forecast is most typical for the entire set.