The Federal Reserve’s monetary policy meeting will be a focal point for markets this week. The two-day meeting will culminate in a policy decision, new economic projections, and a press conference from Fed Chair Jerome Powell on Wednesday. An interest rate hike is almost a foregone conclusion: Fed funds futures are pricing in a 98% chance of an interest rate increase. Markets will be more focused on implications for policy direction through the end of 2019, as the Fed tries to move toward a neutral policy stance without overtightening.
Investors’ attention has largely shifted from the current fed funds rate to the Fed’s projections for future policy and economic growth [Figure 1]. Currently, the markets are parsing the Fed’s words for clues on the “neutral rate,” or the point where monetary policy is neither stimulative nor restrictive. The neutral rate is a practical idea rather than a known macroeconomic variable, and it takes a pragmatic policy approach to move toward the neutral rate while avoiding the risks of overtightening or leaving policy too loose.
We get some sense of the Fed’s current views on rates via the projections provided at every other meeting. These estimates, provided by each member of the Fed’s Board of Governors and the regional Fed bank presidents, capture the projected level of rates at the end of each year and in the “longer term,” with each view represented by an unlabeled dot, which gives the “dot plot” its name.
The last set of projections, released following the June meeting, implied that policymakers expected a slower pace of rate hikes moving into next year. The median dot plot forecasted four rate hikes in 2018 (to a fed funds rate range of 2.25–2.5%), and three hikes in 2019. The “neutral rate” estimates correspond to the longer-term expectations, with a median of between 2.75% and 3.0%. But the longer-term estimates cover a wide range, from as low as 2.25% to as high as 3.5%. It’s also important to keep in mind that the neutral rate is not necessarily a single point, but likely covers a range in which policy could still be considered largely netural.
One signal that we’re approaching that range will be the Fed’s removal of the description of current policy as “accommodative” in its policy statement. While this change may create shortterm uncertainty for markets as they absorb the implications, in the end, earlier removal would likely be more market-positive than later removal, since it would signal that we were near the neutral rate. We think the language is unlikely to change at this meeting, but the discussion is actively taking place and a change at the current meeting is possible.
The Fed will also provide an updated forecast for U.S. economic growth. This particular update could shed light on the Fed’s evaluation of the economy’s generally positive signals along with some potential crosswinds, which have intensified since policymakers’ June forecast of 2.8% gross domestic product (GDP) growth this year.
Overall, U.S. economic data has improved modestly. The economy grew at 4.2% in the second quarter, the strongest quarter of growth since 2014. The job market continues to tighten amid solid payroll growth, while the unemployment rate has dipped to an 18-year low. Spending has also picked up significantly as U.S. businesses and consumers realize a $350 billion windfall from fiscal stimulus. Personal incomes have risen at the fastest pace in nearly three years, while wage growth is at its strongest level of the cycle. We think modestly accelerating wage growth will continue to boost personal incomes and fuel consumer spending, which accounts for about 70% of GDP.