We have adjusted our Fed call, and now our baseline is three hikes in 2019, rather than four. All told, our modal call is now four hikes in 2018, three hikes in 2019, and one hike in 2020. We made this adjustment, not because of any change in the macroeconomic outlook. Rather, the adjustment reflects a reassessment of the FOMC’s reaction function in light of recent remarks and an accompanying rebalancing of the risks around our call, which we had already seen as tilted toward a slower pace of hikes next year.
The qualitative story is the same as before. With inflation near the objective already, the unemployment rate already well below the estimated NAIRU, and the outlook for growth strong, we are headed for a modest overshoot of the inflation objective and an even lower unemployment rate. That outlook calls for a continued gradual pace of rate hikes to the neutral fund’s rate, with a fairly high bar for deviating significantly from that plan. It also calls for an eventual modest overshoot of the neutral fund’s rate, which was reflected in the FOMC’s March funds rate projections.
What has changed is our thinking about how the FOMC will behave next year as inflation rises modestly above its objective and the funds rate nears estimates of the neutral rate. Our thinking had been that, with inflation clearly moving above its objective in 2019, the FOMC would be inclined to stick to a pace of one hike at each meeting with a press conference and projections, raising the fund’s rate beyond the neutral rate by the end of 2019 and further so in 2020.
But FOMC participants appear to be comfortable with inflation modestly above 2%. Participants have noted that such a modest overshoot would be consistent with the asymmetric inflation objective following a period when inflation has been persistently below 2%. Rather than expressing concern that inflation expectations might rise above 2%, a number of participants see overshooting 2% as helpful in raising inflation expectations that may be below 2% today.
The risks and costs associated with accommodative policy and an accompanying inflation overshoot seem limited, while the risks and costs associated with an overly tight policy are much more severe. FOMC participants don’t want to tighten too quickly, thereby risking choking off the expansion or having to change course abruptly. In that regard, a number of participants have expressed concern about tightening to the point that the yield curve inverts. While FOMC participants have emphasized the need to normalize the stance of policy at about the recent pace to get to neutral, there has been increasing discussion of a desire to pause around neutral, especially given the uncertainty around estimates of the neutral rate, the increased risk of recession when the funds rate moves beyond its neutral level, and the lags with which monetary policy affects the economy.
Even those FOMC participants who wouldn’t frame it as a “pause” would still be very cautious about proceeding past neutral. For example, Governor Brainard just yesterday said, “This outlook suggests a policy path that moves gradually from modestly accommodative today to neutral–and, after some time, modestly beyond neutral.” The projected deceleration in growth in 2019 and stabilization of the unemployment rate should reassure policymakers that policy is no longer loose and that they can proceed cautiously with further funds rate hikes.