John Lynch Chief Investment Strategist, LPL Financial
The Federal Reserve (Fed) wrapped up its most recent monetary policy meeting on Wednesday, September 26. While the Fed raised its policy rate, as expected, the more important outcome was the Fed’s guidance on future policy through its statement, a new set of forecasts, and Fed Chair Jay Powell’s press conference after the meeting’s conclusion. The Fed walked a fine line between minimizing the possibility of a harmful pickup in inflation while emphasizing the strength of economic growth and the labor market. However, the market’s response shows the disconnect between the Fed’s and the market’s expectation for future policy is growing.
At every second meeting, along with its policy decision and statement, the Fed provides economic and policy projections based on the individual projections of the 12 regional Fed presidents and the 7 members of the Fed’s Board of Governors (with some seats often unfilled due to transitions). Fed members update their interest rate projections in the Fed’s well-known “dot plot” [Figure 1], with each estimate represented by an unlabeled dot. The Fed’s new dots show policymakers project one more rate hike this year (to a fed funds target range of 2.25–2.5%), along with three rate hikes next year (to a range of 3–3.25%).
While Powell stated several times in Wednesday’s press conference that the Fed will move forward with gradual rate hikes, the median dot of each forecast implies that policymakers expect the pace of hikes to start slowing next year. The dots show that members expect the fed funds rate range to peak at 3.25–3.5% at the end of 2020 before declining to a “longer-term” rate of 3%. This longer-term projection is the best gauge of 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. Although the median estimate for the longer-term rate is 3%, the dots project a longer-term rate anywhere from 2.5–3.5% [Figure 2]. The takeaway here is that although the longer-term projection is a helpful indicator, there is still a degree of uncertainty in determining the neutral rate; and ultimately, the incoming economic data will continue to determine the policy path that provides that best balance of the Fed’s dual mandate of price stability and maximum sustainable employment.
WHAT’S THE STORY BEHIND THESE FORECASTS?
When deciphering the Fed’s forecasts for economic variables, we think it can often be helpful to look at the story that these forecasts tell collectively. Here’s a look at the current overall picture based on the updated forecasts:
Working from median projections, the Fed expects the economy can grow at 2% in the long run. Right now, with the help of fiscal stimulus, it’s growing above that rate. The Fed expects growth will end up at around 3% in 2018, then slow down to a still above-trend rate of 2.5% in 2019, and then will come back in line with longer-term expectations in 2020. To help control the prospects of inflation that can come with above-trend growth, the Fed believes it will have to gradually raise rates, but doesn’t need to be aggressive. Through the end of 2019, the Fed expects it will raise rates at just about every other meeting to keep inflation under control, and then can slow down from there. If the Fed does that, it believes inflation will stay near the stated target of 2% despite the above-trend growth while causing minimum disruption to the economy. Although the Fed is removing added support to the economy, which can be perceived as putting on the brakes, it’s really just trying to get to the point where it’s letting the economy stand on its own two feet.