Go Directly to Neutral. Don’t Pass Go!

The FOMC’s priority is getting to neutral.  

▪ Given initial conditions and the outlook, there is no case for remaining accommodative. ▪ However, they still want to maintain a gradual pace, which is no more than four hikes a year. 

Once at neutral, the Committee will want to proceed more cautiously. 

▪ The FOMC is balancing the need to tighten enough to contain inflation within an acceptable range above  2% and the risk that moving too aggressively could precipitate a recession. 

▪ Some on the Committee are worried about tightening to the degree that the yield curve inverts and to the point that the funds rate overshoots estimates of the neutral rate. 

▪ Further hikes will exacerbate the risk of inverting the yield curve and raising the fund’s rate too far above its neutral level, which is difficult to determine in real-time. 

Consistent with this, we expect: 

▪ The FOMC will raise the fund’s rate target range by 25 basis points at this meeting. ▪ The median dot for 2018 will likely move up to four hikes this year, though there will be a sizable contingent still at three. 

▪ Our expectation is that the median dot for 2019 will also shift up so that the median-implied pace will remain three hikes in 2019. 

▪ If, as we expect, the June median dots show one additional hike over 2018 and 2019 relative to the  March median dots, then the 2020 dots would likely show only one rather than two hikes that year. So we expect the median dots to show a slightly faster path toward neutral, but the same degree of overshoot of neutral (two hikes) by the end of 2020. 

The dots will follow the macro projections.  

▪ Participants will project faster growth in 2018, a lower unemployment rate at the end of this year and through the end of 2020, and (perhaps) slightly higher inflation. 

▪ The dots will be revised in line with the macro projections. But the dots will also reflect caution about the cumulative amount of tightening. 

We think the post-meeting statement will feature more rewriting than there has been for some time and will likely be shorter. 

▪ The sentence stating that policy remains accommodative will likely be omitted, but it could also remain in an amended form. 

▪ Also omitted will be the reference to the funds’ rate running for some time below levels considered to be normal in the longer run. 

The Outlook Context 

Since the March FOMC, there have been two main developments that will be reflected in revisions to the  June macro projections. The first is that growth in the first half of 2018 has surprised us to the upside. In March,  the recent spending data were showing a sharper-than-expected slowdown, but one which the FOMC was comfortable looking through, given the fundamentals. But now it appears that the rebound in Q2 is even stronger than anticipated, and the FOMC will likely mark up its growth projections for this year. The other big development is that the unemployment rate fell faster than anticipated since March, three tenths over April and May. FOMC participants are likely to mark down the projected path of the unemployment rate by at least a tenth, and perhaps two. The incoming price data, in contrast, have been about as expected. We still expect  2.1% core PCE inflation in 2018. However, because the FOMC projected 1.9% in 2018 in March, we think they could mark that up a tenth. This is the outlook context for monetary policy, and it calls for a quicker pace to neutral. 

Key risks to this baseline: 

▪ Unemployment rate bottoms out at 3.5%.  

▪ Core PCE inflation in 2018 unchanged at 1.9%. 

▪ Core PCE inflation in 2020 marked up a tenth, to 2.2%. 

▪ Longer-run unemployment rate marked down a tenth, to 4.4%. 

More Momentum, Even Before the Full Effects of Fiscal Stimulus 

In our own macro forecast, we revised up first-half growth by ½ percentage point, largely because growth in  Q2 is projected to be above 3½%. In 2018:H2 and beyond we see the growth outlook as little changed, as the greater momentum is offset by somewhat less accommodative financial conditions, the appreciation of the dollar, and (to a lesser extent) the rise in oil prices. In our forecast, that leaves growth for 2018 at 3%,  up two-tenths. We are relatively confident that the median growth projections will be revised in a similar manner: a modest upward revision to the growth projections for 2018 and little change in the projections for  2019 and 2020. 

Lower Unemployment Rate, Perhaps to Below 3½%! 

Since March, the unemployment rate fell faster than we’d anticipated, three tenths over April and May. That led us to mark down our unemployment rate forecast, but only by a tenth since we’d long expected the unemployment rate to resume declining. With the unemployment rate has declined more than the FOMC  anticipated, and the growth outlook somewhat stronger, FOMC participants are almost certain to mark down their projections for the unemployment rate. The question is by how much. If the medians for 2019 and 2020  fall only a tenth, they will be at 3.5%, only three tenths below the current level of 3.8%. Given the strong growth outlook, that’s a quite modest further decline in the unemployment rate. That’s why our baseline is that they’ll mark down the unemployment rate to 3.4%. However, it’s quite a close call, as they may be hesitant to make a two-tenths revision in one forecast based on a sharp decline in the unemployment rate over only two months. There’s also a chance that, given the low levels of the unemployment rate and the lack of apparent overheating, projections for the longer-run unemployment rate could shift down somewhat. 

Still Only A Marginal Overshoot of the Inflation Objective 

While our own forecast for core inflation (which has been higher than the FOMC median) hasn’t changed much since March, there is scope for the FOMC’s median projection to move up. In our forecast, core PCE  prices over the remainder of 2018 increase at their average pace over the last six months, which is enough to bring core PCE inflation to 2.1% for the year. A meaningfully slower pace of increases would be needed for core PCE inflation to be 1.9%, the FOMC’s projection from March. For that reason, we expect the FOMC’s median core PCE inflation to be marked up a tenth in 2018, to 2.0%. However, we do have some lingering doubts about this call! 

Finally, we expect that the median projection will remain 2.1% in 2019 and 2020, but there is a possibility that the 2020 figure could edge up a tenth. The downward revision to the path of the unemployment rate,  especially if it’s two tenths, would push in the direction of a higher core inflation projection–but not much,  given the flatness of the Phillips curve. We lean toward the view that FOMC participants will, like us, see the outlook for core inflation in 2019 and 2020 as little changed since March. 

The FOMC Call 

Of course, there will be a 25-basis-point increase in the target funds rate. The news will be in the macro and rate projections, and the key in the press conference will be for the Chair to tell a story linking the changes in the rate projections to revisions in the macro projections. The Committee appreciates that there is no longer a case for remaining accommodative: No need to further strengthen the labor market to push inflation back to 2%. That was yesterday’s mission. Today’s is dealing with being behind the curve as fiscal stimulus is added to an economy with growth already above trend, an unemployment rate already below the NAIRU, and core PCE inflation at or virtually at 2%. Therefore, the first priority for the Committee is to keep raising rates until the fund’s rate reaches its neutral level. There is a self-imposed constraint, understandable at this point,  of maintaining a gradual pace of no more than four hikes a year. So we expect hikes at every other meeting,  no pauses, until reaching neutral. That leaves the question of what to do at that point. We think the Committee will likely opt to pause because the second priority is to avoid tightening too aggressively and precipitating a recession by hiking the fund’s rate well above its neutral level. This is the tradeoff we have emphasized:  tightening more cautiously to lower the probability of recession and accepting inflation in the 2%-2½% range.

Priorities 

1. Get to neutral, do not pass go! 

The policy should no longer be accommodative, but it is. Nevertheless, the Committee has committed to a gradual pace: No more than four hikes a year. Respecting that constraint, they should move by 25 basis points at each meeting with a press conference and updated projection until they reach the neutral level of the fund’s rate. 

2. Once at neutral, proceed more cautiously. 

Here is where the tradeoff between containing inflation and avoiding a recession comes into play. Most likely,  policymakers will opt to pause after getting to neutral, as there is more uncertainty about how much to move above the neutral rate and where the neutral rate is. The more it moves above neutral, the greater the probability of a recession.  

3. Act and communicate in a manner consistent with asymmetric inflation objectives.  Many participants have made clear that they are comfortable with a modest overshoot of the 2% objective.  This is likely the consensus view on the Committee. As we have said, we expect them to act consistent with an inflation-control range of 2%-2½%, with an unambiguous point objective of 2% and with the aim to average 2% over time. 

The Dots  

The median dots in March for 2018 were consistent with three hikes this year, but just barely. The revisions in the macro outlook at the very least call for a faster pace toward the neutral rate. Therefore, we expect the median dot in 2018 to rise to a level consistent with four hikes. Of course, it would only take one participant moving from three hikes to four for the median to shift, so this alone would hardly be a material change in policy intentions. Even with an upward shift in the 2018 dots and a move in the median to four, we expect there would still be a sizable contingent at three. So the message will still be “three or four hikes this year”– 

the same basic story as in March–but with a more-apparent lean toward four.  

If the FOMC raises rates three more times this year, the fund’s rate will be just two 25-basis-point moves away from neutral at the end of this year, given that estimates of neutral are in the range of 2¾%-3%. Given our expectation that they are now prioritizing progression to neutral without any breaks along the way, we expect hikes in March and June 2019, which would take them to neutral. Once there, we think they’ll pause in September 2019. Then in December, we expect them to take the first tentative step past neutral, raising rates a third and final time in 2019. As for the median for 2019, we think it will move up 25 basis points.  That would likely be seen as hawkish, but it’s fairly easy to achieve, as only two dots would have to move up. We still expect the dots for year-end 2019 to exhibit a good deal of dispersion. 

The number of hikes in 2020 depends on how much the Committee is prepared to overshoot neutral. In the  March dots, they ended up 50 basis points above neutral at the 2020 year-end. We don’t think they will have changed that assessment since March, so we expect the median to be at the same level. Assuming that the median dots imply one more hike in 2018, relative to March, and the same number in 2019, this would entail one fewer hike in 2020. 

Please Tell A Story 

Previous Fed Chairs used participants’ macro and rate projections to tell a story that was underpinned with the logic of policy rules, and over time revealed the FOMC’s reaction function. Powell opted not to do so at his first press conference, which we see as a bit of a missed opportunity. He mostly emphasized the challenges of forecasting and the inherent uncertainty of projecting interest rates in 2020.  

Powell may have an opportunity to soften the message from the SEP if the macro and rate projections are revised in the directions we have discussed. For example, the median dots for 2018 and 2019 moving up would likely produce a hawkish market response. But he could emphasize, as in March, that the dots still point to three or four hikes in 2018 and that the median moving to four does not guarantee that number of hikes. 

The Statement: Time for A Rewrite? 

Look at the dots first, because we know the direction of the macro projections. The statement is mostly interesting because of the prospect that there will be some re-writing, specifically to remove language that is stale or no longer informative.  

The May 2018 FOMC minutes highlighted issues with two parts of the statement discussing the stance of policy being accommodative. Here’s the full section: 

Participants commented on how the Committee’s communications in its post-meeting statement might need to be revised in coming meetings if the economy evolved broadly as expected. A few participants noted that if increases in the target range for the federal funds rate continued, the federal funds rate could be at or above their estimates of its longer-run normal level before too long. In addition, a few observed that the neutral level of the federal funds rate might currently be lower than their estimates of its longer-run level. In light of this, some participants noted it might soon be appropriate to revise  the forward-guidance language in the statement indicating that the “federal funds rate is likely to 

remain, for some time, below levels that are expected to prevail in the long run” or to modify the  language stating that “the stance of monetary policy remains accommodative.” Participants expressed a range of views on the amount of further policy firming that would likely be required over the medium term to achieve the Committee’s goals. 

After the minutes came out, FOMC participants chimed in, expressing their displeasure with the language.  For example, Williams (June 1) said: “[‘For some time’ is] no longer either accurate or…really that useful.” 

The period implied by “for some time” has been getting shorter and shorter, and the Committee would already be closer to a neutral rate given economic circumstances, if not for a desire to raise rates at a gradual pace.  Accordingly, the emphasis should no longer be on remaining accommodative, but on removing accommodation, if anything. We think this part will be dropped. 

As for the line that “the stance of monetary policy remains accommodative,” there is a range of views about how accommodative monetary policy currently is. It’s plausible that they could say that monetary policy remains “modestly accommodative,” language recently used by Brainard. But this would only be kicking the can down the road. In our statement guess, we have the FOMC dropping this line entirely, but we see some likelihood that it could remain.  

While it’s highly uncertain how the FOMC would revise the statement to address these issues, we think a  reasonable approach would be to consolidate the third and fourth paragraphs, using much of the existing language. The question is whether the statement will say that the Committee anticipates gradually raising rates until they get to the neutral rate. We highly doubt that the statement would incorporate the story already told by the dots, that the Committee expects, once at neutral, to continue raising rates moving to an outright restrictive posture. The statement simply will not be explicit enough to be consistent with that forward guidance implicit in the dots.  

Of course, there will be the usual changes to the statement to reflect the incoming data. In our statement  guess, we have them keeping the language that economic activity has been rising at a “moderate rate.” The spending data appear to show that growth will be faster in Q2, so they could certainly upgrade this. In  January, they used the term “solid,” but at that point, they had GDP data for Q4 in hand. The unemployment rate will be described as having “declined,” of course. There will also be a reference to the substantial  improvement in the recent consumer spending data: “growth of household spending picked up after slowing  in the first quarter.”  

The statement will likely continue to say that measures of inflation compensation “remain low.” 5y5y BEI is  approximately 2.1%, having edged down from the prevailing levels preceding the May FOMC meeting (2.2%) when the statement also used “remain low.” This wording has been used repeatedly since mid-2015, when the 5y5y BEI fell to 2.0%, from 2.5% in 2014. 

To upgrade the assessment of the inflation compensation measures at this point would be too optimistic. The  FOMC responded to the late-2017 run-up in BEI by saying “increased in recent months,” immediately followed with the proviso “but remained low” to avoid the risk of this being interpreted too hawkishly. The level then was higher than it is now.  

We do not expect more material changes. But if there are any, we expect they will reflect Powell’s communications style: shorter, less filler. 

Statement Guess 

Information received since the Federal Open Market Committee met in May March indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate. Job gains 

have been strong, on average, in recent months, and the unemployment rate declined. has stayed low. Recent data suggest that growth of household spending picked up after slowing in the first quarter, moderated from its strong fourth-quarter pace, while business fixed investment continued to grow strongly. On a 12-month  basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent.  Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with further gradual adjustments in the stance of monetary policy,  economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced. 

In view of realized and expected labor market conditions and inflation, the Committee decided to raise maintain the target range for the federal funds rate to 1-3/4 to 2 percent. at 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. 

In determining the timing and size of future adjustments to the target range for the federal funds rate, the  Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation, recognizing that its inflation objective is symmetric. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The  Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate. ; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. 

Voting for the FOMC monetary policy action were Jerome H. Powell, Chairman; William C. Dudley, Vice  Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Loretta J. Mester; Randal K. Quarles; and John  C. Williams. 

IOER: Technical Adjustment Likely 

With the June funds rate hike, the FOMC will likely raise the IOER rate 20 basis points rather than 25 basis points, as hinted by the May FOMC minutes. If the FF-IOER spread remains at 5bps, then the effective fund’s rate after the June meeting would trade at 1.90% instead of 1.95%. As such, the passthrough to other interest rates from the June hike would likely be only 20 basis points (1.70% to 1.90%) rather than the usual  25 basis points. The June hike would even out the March hike, after which the effective rate rose almost 30  basis points, from 1.42% to 1.70%.  

The relevant change in the implementation note will likely read: 

The Board of Governors of the Federal Reserve System voted unanimously to maintain the interest rate paid on required and excess reserve balances at 1.75 percent, effective May 3, 2018. to raise the interest rate paid on required and excess reserve balances to 1.95 percent, effective June 14, 2018.

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