Laying the Groundwork for 2019

The FOMC will raise the fund’s rate at its December meeting, as is widely anticipated. While the fund’s rate decision won’t be very interesting, changes to the language in the statement, the macro projections, and the dots will be. There will be a lot to explain, so Chair Powell’s press conference will be important as well. It will be especially important in light of his recent public remarks, which have fueled market speculation and confusion. 

The broad contours of the economic outlook remain the same as at the time of the September FOMC meeting when participants last submitted projections. The incoming economic data haven’t warranted a  reconsideration of that outlook. See our Macro Views for our updated forecast. 

▪ Real GDP has grown at a strong pace this year, boosted by a run-up in equity prices and fiscal stimulus.  But a slowdown in growth is expected beginning in 2019 and continuing over the forecast horizon. ▪ The labor market is tight and continues to tighten. The unemployment is already well below the estimated  NAIRU, and even with significant moderation in growth in 2019 is expected to decline somewhat further, to around 3½%. 

▪ Core inflation is fairly close to 2%, and, with the unemployment rate projected to fall even further below the NAIRU, is expected to rise further. However, because of the flatness of the Phillips curve, this rise is expected to be very gradual and result in only a modest overshoot of the 2% objective. 

This outlook clearly supports the FOMC’s policy of gradually raising rates to remove remaining monetary accommodation. 

▪ Financial conditions have tightened in recent months, however, and policymakers, most notably Powell,  have signaled a more cautious approach to raise rates as the fund’s rate gets closer to a neutral level. ▪ Those changes led us to remove one rate hike in 2019 in our baseline. We now anticipate quarterly hikes through June 2019. 

▪ At that point, with growth clearly slowing, the FOMC will be focused on sustaining the expansion and concerned about recession risk. Thus, we anticipate no further rate hikes after the two in 2019. ▪ We anticipate that the following move will be a rate cut in late 2021. 

In our own forecast, removing one rate hike roughly offset the effect of tighter financial conditions. We anticipate that FOMC participants will make similar adjustments to their own projections. ▪ We expect the December median dots to show one fewer hike in 2019 than the September dots: two hikes in 2019, one hike in 2020, and no hikes in 2021. 

▪ While we don’t expect many of the longer-run dots to move, the September median was just barely at  3%, and it would take little for this to edge down in December. 

▪ With financial conditions tighter but participants also assuming a lower path of the fund’s rate, we anticipate participants will revise down 2019 growth modestly. 

▪ The projected path of the unemployment rate is unlikely to change meaningfully: a decline to 3½%, then a slight rise. 

▪ Core inflation has come in softer than consistent with the FOMC’s September projection of 2% in 2018.  They will mark that down, and may also markdown 2019 a tenth, to 2.0%, as well. They are likely to continue projecting a modest overshoot in 2020 and 2021. 

There are likely to be meaningful changes to the statement. 

▪ FOMC participants have signaled that they want to move away from the “further gradual” language in the statement. We think they’ll drop it at this meeting. 

▪ We expect some minor changes to the backward-looking first paragraph and see a possibility of a more significant change, an acknowledgment that market-based measures of inflation compensation have declined in recent weeks. 

▪ While this would be seen as a dovish change to the statement, it’s a change that is warranted by the magnitude of the move and the FOMC’s past characterization of these measures in similar circumstances.

“Look Out the Window” Will be the 2019 Approach 

(We begin with a general discussion of policy strategy, before providing specific baseline forecasts and risks  for the FOMC statement, SEP macro projections and dots, and press conference.)  

A funds rate hike next week is a foregone conclusion. With Powell and most others had already signaled a December hike and markets pricing it in, there is little reason to forgo a hike. The expected partial U.S.  government shutdown next week won’t be relevant. 

The more interesting question is the prospect of further tightening next year. The FOMC’s current guiding principle is to sustain economic expansion. Therefore, it seeks to defend against recession risk by performing a balancing act between “moving too fast,” which “would risk shortening the expansion,” and  “moving too slowly,” which “could risk other distortions in the form of higher inflation or destabilizing financial imbalances,” in Powell’s words.  

The forecast suggests something close to a soft landing: Growth slowing to just somewhat below trend and the unemployment rate edging back up toward the NAIRU. But such a scenario raises the specter of recession.  The risk of too-high inflation is low. Indeed, policymakers have suggested that the inflation risk is to the downside. The risk of financial instability is moderate. Neither risk warrants hiking more quickly. This means stopping earlier and not going as far.  

Policymakers have stressed the iterative nature of data dependency. Clarida’s speech presented this  framework as a two-stage process: 

1. Translate revisions of the forecast to the balance of risks around the policy path. Incoming data reveal the state of the economy relative to the dual-mandate goals. 

2. Update estimates of key parameters. The forecast might change, not just because the data are different, but because the data tell us the stars (r*, u*) have changed. This changes the ultimate destination.  

The nature of this framework shifts the center of gravity of forwarding guidance from the FOMC statement and  SEP to Powell’s press conference. A significant portion of the recent change in market expectations can be traced to Powell’s Oct. 3 “long way from neutral” comment and subsequent reversals of that sentiment, most notably the comment that we are “just below” the “broad range” of neutral estimates. The “broad range” is  2.5%-3.5%, with participants tightly clustered in the lower half of that range, between 2.75% and 3%. 

A December hike would raise the fund’s rate to 2.25-2.50%. The next hike (March, in our baseline) would then bring it to 2.50%-2.75%, which would be within the “broad range” of neutral estimates. The focus  would change to the data in hand at each meeting, or what Larry calls “look out the window.” The concept of data dependence then takes priority. Policymakers convey this concept by noting that future policy actions will be increasingly dependent on the evolution of the economic outlook. 

There has been a noticeable shift in sentiment to the dovish side in recent weeks, including by Powell and  Clarida. Some of the doves have become more vocal about their opposition to a December hike, although that is not sufficient to prevent it. Quarles noted that the debate has shifted to where the terminal funds rate will be “within” the broad range, confirming that any sentiment that it will be appropriate to move into the clearly restrictive territory has eroded considerably. 

While we have two rate hikes penciled in for 2019, the ultimate number is constrained by the timing of the first hike. The later the first 2019 hike is, the less likely it is that there will be two or more rate hikes that year. This is because, while there will likely be some evidence of slowing at the March meeting (but not definitive) and more evidence in June, the data are likely to definitively show a slowing in growth and the labor market by September. Thus, it will be much more difficult to pursue rate hikes in the second half.

We have removed one 2019 hike, and we expect participants’ median to do the same, likewise showing two hikes in 2019. Such a change is warranted by the meaningful tightening in financial conditions since  September. However, the FOMC won’t want to give the impression that the primary reason is a “Powell put”  response to lower equity prices. In addition to the tightening in financial conditions, participants can point to muted inflation, a decline in breakeven inflation rates, and concerns about downside risks to the outlook for real GDP growth as supporting a change in policy assumptions. 

However, we diverge from the FOMC’s dots after 2019. The median FOMC dots showed one additional hike in 2020, and we expect them to keep that. But we find the 2020 hike to be implausible. Given the direction the economy is expected to be heading at that point, it is difficult to imagine the FOMC resuming rate hikes at that point, especially into restrictive territory. In contrast, our baseline has no further hikes in 2020, and we have a rate cut in 2021 in response to a perception of rising recession risk in the face of the upturn in the unemployment rate. Indeed, after the June 2019 hike, we see the risks of the next move being weighted more to an easing than a tightening—despite the likelihood that participants’ dots could continue to signal further tightening ahead. An important consideration for the timing and aggressiveness of any easing would be the prospect of being constrained by the zero lower bound in the event of a recession. 

One particular risk to our baseline of hikes in March and June we’d like to flag is the possibility that the first hike of 2019 will be postponed to May (rather than June). Geopolitical reasons, such as Italy, Brexit, and  U.S.-China trade tensions could be relevant factors and encourage a temporary risk management posture.  From a communications perspective, a delay to May has the advantage of allowing the FOMC to say that it was merely postponing a March hike that would have been appropriate but for those specific circumstances,  not pursuing an outright Q1 “pause” (which would more likely be the perception if hikes were skipped at both the March and May meetings). Powell has prepared for that possibility with his repeated claims that even non-SEP meetings are live and by introducing press conferences at every meeting beginning in 2019.  Regardless of whether the hike is postponed to May or June, it still leaves open the option of hiking a second time, likely in September.  

Balance sheet normalization is unlikely to be a key feature of the December meeting, although discussion of this issue could emerge in the press conference and FOMC minutes. As for its interaction with the downward revision to the anticipated rate path, it remains unclear at this stage if the FOMC will as a consequence opt to suspend balance sheet runoff earlier than otherwise intended. While the default stance remains to keep balance sheet normalization as a passive policy tool in the background, we expect that when the FOMC eases with its rate policy, it will not continue to tighten with its balance sheet policy. 

  • FOMC Statement 

(Our guess of the statement is appended to the end of this document.) 

  • Further Gradual 

The November FOMC minutes revealed that the FOMC thought “its post-meeting statement might need to be  revised at coming meetings, particularly the language referring to the Committee’s expectations for ‘further  gradual increases in the target range for the federal funds rate.” Furthermore, “many” thought it might be  appropriate at “some upcoming meetings to begin to transition to statement language that placed greater  emphasis on the evaluation of incoming data in assessing the economic and policy outlook; such a change  would help to convey the Committee’s flexible approach in responding to changing economic circumstances.”  

We expect a decisive transition to data-dependent language. This is what the FOMC did in June when they removed the language in the final paragraph describing their expectation that further gradual rate hikes would be appropriate and that the fund’s rate would likely remain below longer-run levels for some time. Variations of “no preset course” and “data dependency” will be considered. Likely comments, although not necessarily  in the statement, will be along the lines of: “Future policy actions will be dependent on the evolution of the  economic outlook.” Keeping language about further tightening would require the FOMC to consider minor 

adjustments at each upcoming meeting. Any such changes would have the potential to be misinterpreted and,  in any case, the language would have to be removed eventually. As in June, the FOMC can remove the language then have Powell explain the change in his press conference. 

The FOMC could modify the “further gradual” sentence to this: “The Committee expects that, with an appropriate adjustment in the target range for the federal funds rate, there will be sustained expansion of  economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent  objective over the medium term.” It wouldn’t be surprising if the FOMC considers making more substantial revisions to the statement as part of this change. For example, the second and fourth paragraphs could be combined for brevity. Such a change wouldn’t change our thinking on policy. 

While we see little appetite for fine-tuning, rather than removing, this language pointing to expectations of further tightening, we don’t rule it out entirely. After all, the minutes hinted they thought they had some upcoming meetings (plural) to accomplish such a shift. Numerous variations have been floated in recent months by policymakers, and these indicate what a fine-tuning approach might look like  (Clarida’s “some” further gradual “adjustment” and Williams’ raising interest rates “somewhat,” for example). 

Downgrade in Inflation Expectations Possible 

In addition to the tightening in financial conditions and somewhat softer outlook, another driver for a shallower rate path could be concerned about a possible softening in inflation expectations. Clarida has emphasized the importance of readings on inflation expectations for his views on the appropriate policy path, and some others have mentioned this as well. Citing this factor also provides further support for a shallower rate path and helps distance the FOMC from the impression that it is adjusting policy in a dovish direction based on moves in equity prices or political pressure.  

Recent declines in TIPS-implied breakeven inflation rates could well warrant a downgrade in the characterization of inflation expectations in the first paragraph. In June, the FOMC dropped the characterization of market-based measures as remaining low and moved to the current language that lumps together market-based and survey-based measures (“Indicators of longer-term inflation expectations are little changed, on balance.”). The five-year, five-year forward breakeven inflation rate is now roughly 1.95%, below the threshold under which the FOMC statement has previously assigned the “low” label. The interesting  decline of roughly 15 basis points is sufficiently large that it would be a stretch to keep the current language,  “little changed, on balance.” We think this decline is sufficient to assign a “declined somewhat” description.  But this is a close call. Such a change would be purely a response to the incoming data. Downgrading the description in inflation expectations might take too much tightening out of market expectations for the  FOMC’s comfort.  

As for the survey-based measures, the University of Michigan’s longer-term measure has remained low (2.4%,  only barely above the cycle low), but that’s not a recent change. It’s been moving sideways for some time.  The Survey of Professional Forecasters’ measure remains steady at 2%, as usual. We expect them to return  to the language that survey-based measures are “little changed, on balance.” It’s possible they could consider other options, but these would likely be seen as signaling too much dovishness.

Avoiding Comment on Financial Conditions in the Statement 

Despite the recent drawdown inequities, the statement is unlikely to cite the recent deterioration in financial conditions. The Powell FOMC will be careful not to give the impression that any easing in the projected rate path is primarily in response to declines inequities and, even more importantly, pressure from President Trump urging the Fed to keep policy easy for the sake of financial market performance. (This issue is separate from  the boilerplate language about monitoring “readings on financial and international developments,” which will  likely remain unchanged.) 

Other Minor Changes to Opening Paragraph 

In addition to the more substantial changes to the statement described above, there will be some tweaking of certain language in the first paragraph on the incoming data. We don’t see these possible changes as very significant. The unemployment rate stayed at 3.7% in November, so we think they’ll say it “stayed low”  (previously used language) rather than “declined.” There’s also a possibility that they’ll return to describing job gains as “solid” rather than “strong,” to reflect somewhat softer gains over the last few months, on average. However, the six-month average is still close to 200K. On balance, we think they’ll just stick with the current language. They will likely continue to describe household spending as strong, despite residential investment continuing to look soft, as consumer spending has been robust. As for business fixed investment,  in November, with GDP data for Q3 in hand, they said it “has moderated from its rapid pace earlier in the  year.” Now they’ll likely move to characterize the pace, rather than describing the change relative to earlier in the year. The 2.5% pace of BFI growth in Q3, as well as the initial data for Q4, suggest they’ll  characterize it as “moderate.” 

IOER Adjustment Expected 

The November FOMC minutes contained a strong signal that a December funds rate hike would be accompanied by an under-25bps IOER rate hike (+20bps, from 2.20% to 2.40%). The urgency of such an adjustment was underscored by the approval of a contingency plan for an outright cut in IOER between FOMC  meetings. The IOER adjustment will be presented as purely technical, as per usual. An adjustment larger than  -5bps is unlikely (though possible). 

Dissents 

The December 2018 FOMC meeting is not likely to elicit any dissents. We don’t see Bostic as likely to dissent,  nor do we see dissent as affecting the outcome of the FOMC statement.  

SEP Dots 

▪ 2018: The consensus for a fourth (December) 2018 hike will remain strong, although we expect that the number of dots at three hikes will edge up as a result of recent unease from more policymakers. This does not affect the prospects for a December hike but drags down the distributions for 2019 and beyond as a result of base effects. 

▪ 2019: We expect the median for 2019 to fall 25 basis points, or from three hikes to two hikes, to offset the effects of the deterioration of financial conditions. This is also consistent with the shift in sentiment among participants that we have noted. The baseline case below shows the median (ninth) participant at two hikes, but the distribution as a whole could still be close to three hikes if more policymakers remain at three hikes than we anticipate. Conversely, there could be a more powerful shift among policymakers toward only two, or even one, hike in 2019.  

▪ 2020 and 2021: We continue to see the FOMC median retaining the single 2020 hike, even as the median number of 2019 hikes declines from three to two. At an individual level, removing two hikes might be considered an overreaction to the change in circumstances. With the fall in the 2019 median dot, the endpoint for the fund’s rate will be 25 basis points lower. As we noted, we find the projected hike in 2020  inconsistent with the economic circumstances projected for that time, particularly the leveling off of the unemployment rate and slowdown in real GDP growth.  

▪ Longer run: We don’t expect many of the individual longer-run dots to be revised, and our baseline expectation is that the median will remain at 3%. However, there is a substantial probability that it will move lower given the distribution of September dots. In September, the median was just barely at 3%;  one more dot below 3% would have moved the median to 2.75%. There may also be a compositional effect, as the SEP will include the addition of dots for Governor Bowman, whose longer-run dot may also fall below 3%. With the continued absence of a longer-run dot for Bullard, the median could, again, end up in between 2.75% and 3%, at 2.875%. (A very remote risk is that Bullard begins to submit a longer 

run dot, which would fall below 2.5%. But this is highly unlikely, in our view, and would not change the  interpretation that the broad range of neutral means 2.5% to 3.5%.) The posture of monetary policy in  2019, 2020, and 2021 will be judged relative to the neutral estimates. So a downward shift in a  participant’s longer-run dot, all else equal, suggests a greater likelihood of them shifting to a lower funds rate path.  

Participants’ Macro Projections 

The incoming economic data since the September FOMC meeting have come in broadly consistent with participants’ September projections and warrant only modest adjustments. Changes in financial conditions warrant greater changes to the outlook. However, we expect many FOMC participants to mark down their projected paths of the fund’s rate, offsetting some of the effects of tighter financial conditions on the outlook.  

Below is a table showing the September median FOMC projections as well as projected revisions for the  December SEP. The projected revisions essentially assume that participants revise their September projections based on changes in the incoming data, financial conditions, and monetary policy assumptions. Notably, we assume they don’t resolve what we saw as internal inconsistencies in the September median projections,  particularly concerning Okun’s Law. For example, the unemployment rate falls two tenths in 2019 when growth is 0.7 pp above its longer-run level, but in 2021 the unemployment rate rises two tenths when growth is at its longer-run level. 

Growth 

In September, FOMC participants projected a 3.1% growth this year. That’s what we now project, and we expect they’ll continue to project 3.1% growth in 2018. The incoming data have likely come in only slightly soft relative to FOMC participants’ expectations. The data plus tighter financial conditions will likely warrant the FOMC taking a tenth or two off growth in 2019. In our own forecast, we trimmed 2019 growth but added a bit in 2021 to reflect our lower assumed path of rate hikes. As a base case, we expect participants to take a couple of tenths off 2019 growth without adding at all to growth later in the forecast, however. 

Labor Market 

It’s quite possible, even likely, that the median unemployment rate could edge up or down a tenth for certain years, but as a base case, we have no revisions. The labor market data have come in broadly consistent with the September projections and don’t warrant a change in the jumpoff. Changes to the growth projections likewise don’t warrant a substantial change in the path of the unemployment rate. Even if growth in 2019 is marked down, as we expect, it still seems reasonable for FOMC participants to project the unemployment rate declining at least a couple tenths in 2019, as they did in September. 

Inflation 

We think the FOMC’s core PCE inflation projections will be marked down. In September, they kept their median projection for 2018 at 2%, which seemed optimistic to us. We’ve since marked down 2018 to 1.8%,  and we expect the FOMC to mark it down a tenth or two, to 1.8% or 1.9%. We think the core PCE price data through October, and CPI and PPI data for November, point to 1.8% for 2018. But perhaps, as in  September, they will be more optimistic than us and mark it down to only 1.9%. We have taken some signals from the slightly softer core inflation data and marked down the near-term pace of core PCE inflation. That’s led us to mark down core PCE inflation in 2019 a tenth, to 2%. As a base case, we have the FOMC median falling to 2% in 2019 as well. We don’t anticipate any changes to the projections for 2020 and 2021—2.1%.  That’s consistent with our expectation that there won’t be substantial changes to the projected path of the unemployment rate. 

The Stars 

We don’t expect any changes in the median longer-run projections for real GDP growth and the unemployment rate, but a slight shift wouldn’t be surprising. We see a bias toward marking up the longer-run growth projection (currently 1.8%). We also see a bias toward marking down the projected NAIRU (currently 4.5%),  with that bias increasing the longer the unemployment rate remains significantly below the NAIRU without core inflation firming further. 

Press Conference 

Powell is asked about the changes to the statement and to the projections, as well as what he makes of recent market developments, particularly concerning expectations for Fed policy. If they change the statement as we expect, by removing the “further gradual” language, he will likely say something similar to what he said when they revised the statement language earlier this year. He’ll say that FOMC participants thought a language change was appropriate to emphasize the data-dependent nature of policy and the language change isn’t intended to signal anything about specific policy decisions at upcoming meetings.  He can point to the dots as indicating that most participants expect further rate hikes to be appropriate.  Powell will certainly be asked to define the “broad range” of neutral estimates. He will answer by citing the  SEP ranges, as well as model estimates, without divulging any additional information. He will also turn the focus to the data-dependent aspect of policymaking rather than the previous focus on neutral.  

With FOMC participants likely to show a lower path of the fund’s rate in their projections, Powell may be asked about the implications for balance sheet normalization. He is likely to reveal little about the FOMC’s intentions for balance sheet policy, instead reiterating that the FOMC is satisfied with this aspect of monetary policy remaining in the background. The FOMC has shown little inclination to slow or halt its runoff plans in response to the notion that the drawdown in excess reserves is impairing market functioning. We continue to expect the current normalization plan to stay in effect until mid-2019.

Powell is unlikely to mention CCyB in his opening remarks, although there is a good chance he will be asked about it. Brainard noted that the annual determination of whether to activate CCyB would likely occur within the next month. However, no Fed governors other than Brainard support activation. Therefore, Powell will likely sidestep this question and provide no additional information other than to reiterate his earlier conclusion  (derived from the Financial Stability Report) that financial vulnerabilities remain moderate, which would tacitly imply that CCyB activation remains unwarranted.  

Our Baseline Guess of the Statement 

Information received since the Federal Open Market Committee met in September November indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has declined stayed low.  Household spending has continued to grow strongly, while the growth of business fixed investment advanced at a moderate pace has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance. While market-based measures of inflation compensation have edged down recently, 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 appropriate adjustment further gradual increases in the target range for the federal funds rate, there will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced. 

Given realized and expected labor market conditions and inflation, the Committee decided to raise maintain the target range for the federal funds rate at 2 to 2-1/4 percent to 2-1/4 percent to 2-1/2 percent. 

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 maximum employment objective and its symmetric 2 percent inflation objective. 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. 

Voting for the FOMC monetary policy action was: Jerome H. Powell, Chairman; John C. Williams, Vice  Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Richard H. Clarida; Mary C. Daly; Loretta J.  Mester; and Randal K. Quarles.

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