FOMC Keeps Its Focus on the Medium-Term Outlook

We continue to expect two further rate hikes this year, one this week and the other in September, and an announcement in September that the phasing out of reinvestment will begin in October. While recent surprises in the incoming data pushed the Committee in opposite directions, we suspect the FOMC will see the continued decline in the unemployment rate as more significant than the more muted inflation data. 

▪ The unemployment rate has fallen another couple of tenths since the May meeting and a total of four tenths since the March meeting. Its current level of 4.3% is lower than any point on the median projected path from the March SEP. That, not a recent slowdown in the pace of payroll gains, is the important development in the recent labor market data. 

▪ On the other hand, the negative inflation surprises continued after the May meeting. The 12-month core  PCE inflation rate dropped to 1.5% in April, the lowest since late 2015, which will feed doubts about the strength of any upward trend.  

The decision to hike this week will still reflect our “back to the plan with a steadier hand” theme. ▪ As unexpected and eyebrow-raising as the inflation surprise has been, the Committee is prepared to look through it, attributing it for the moment to idiosyncratic and temporary factors. They will focus on the medium term and continue to project a return to the 2% objective by 2019. 

▪ The recent decline in the unemployment rate, on the other hand, will be seen as more enduring.  Participants will relevel down the projected path of the unemployment rate throughout the forecast by two or even three tenths. This part of the outlook will reinforce the Committee’s expectation that inflation will rise to 2% in the medium term. 

While we assume in our forecast that the FOMC will raise rates again in September as well as announce a  change in the reinvestment policy, we don’t expect any concrete signals at this week’s meeting. ▪ As for the dots, we expect the median to still imply three hikes in 2017, but we expect greater support  

for four hikes than in March. This is because we expect FOMC participants to place greater weight on the unemployment rate surprise and to continue for now to treat the weaker inflation data as transitory. ▪ We expect the statement to be noncommittal about a September hike. The FOMC will have to acknowledge the soft inflation data, but we expect they may include language attributing some of the weakness to transitory factors. 

While there appears to be solid support for announcing a change in reinvestment policy at the September meeting, the prospects for another hike in September are less certain. 

▪ For one, the data would have to come inconsistent with the forecast and include indications that the recent softness in inflation is temporary. 

▪ There will also be those on the FOMC who would rather not make an announcement about balance sheet policy and raise the fund’s rate target at the same meeting. 

▪ On the other hand, hiking in September will appeal to those on the FOMC who would like to keep the option open of hiking four times this year. 

It’s a close call, but we expect the FOMC to both hikes and announce a change in reinvestment policy in  September: We see the data as likely to support a hike and concerns about an adverse market reaction as likely to be limited, given how slight and well-telegraphed the change in reinvestment policy will be.  

Two More Hikes and a Change in Reinvestment Policy This Year 

The estimate that the current real equilibrium funds rate is near zero means that the nominal neutral rate today is near 2%. Participants appear to believe that the prevailing real neutral funds rate will converge toward its longer-run value, estimated by the Committee to be 1% (or a 3% nominal funds rate), over the next couple of years. 

We expect the balance sheet to decline from $4.5 trillion to $3 – $3.5 trillion as Treasuries and MBS runoff and reserves gradually decline to a level consistent with maintaining operational efficiency in the current regime. Eventually, purchases of Treasuries will be necessary to offset continued decreases in MBS holdings and because the normalized size of the balance sheet increases over time.

The Rates Outlook

We expect the ten-year Treasury yield to gradually rise as the Fed continues to gradually raise the fund’s rate target. The ten-year term premium is expected to gradually rise, turning positive in 2019. 

The effects of the Fed’s various balance sheet programs on term premiums are already diminishing. Recent remarks from FOMC participants suggest they’re using the estimates of Bonis et al, which suggest that the depressing effect on the ten-year Treasury term premium may increase by about 15 basis points per year through 2019. 

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated In the leftmost column. 

Note on Units and Transformations 

“Quarterly” values are q/q rates; “Annual” values are q4/q4 rates. For series followed by units in parentheses, “Quarterly” values are quarterly averages, and “Annual” values are q4 averages. 

* “Quarterly” values are not compounded to annual rates.

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