Monetary Policy at an Inflection Point

The economy is at an inflection point and, as a result, so is monetary policy. But the outlook has changed  more than the guidance on monetary policy.  

▪ This is the first meeting at which participants will have incorporated the full fiscal stimulus. ▪ That means faster growth, mainly in 2018, and a still-lower path of the unemployment rate. ▪ The key question is whether the median dot for 2018 moves up to imply four hikes or remains at three. 

We don’t expect any surprises in the median macro projections.  

▪ We expect projected growth in 2018 to be revised up, perhaps three tenths in 2018 relative to December.  There will also likely be slightly higher growth over 2019 and 2020. 

▪ We would have expected this revision to be larger, but for the much slower growth now anticipated in  Q1 and the slight tightening of financial conditions.  

▪ We expect a small, but telling, revision to the inflation projections: We expect participants’ median projection for 2018 will be revised up a tenth, to 2%. The message: The slowdown in 2017 really was temporary, reflected in the recent firming. The balance of risks has changed, now to the upside, and we expect the median projections for 2019 and 2020 will soon show an overshoot of 2%, though likely not at this meeting. 

The statement should be on the hawkish side, but not jarringly so. 

▪ The Committee will recognize that the incoming data indicate growth moderated in Q1 but won’t want to convey pessimism. They can do this by simply acknowledging the spending data, and continuing to recognize that employment growth has been very strong. 

▪ Most importantly, we expect the statement to refer to recent inflation readings as “firmer,” consistent with the better readings in the monthly data since the last meeting, and for a few months before that. ▪ They could drop the “roughly” modifier to balanced risk. Small change. 

The most market-sensitive adjustment is the median dot for 2018. Whether it still implies three hikes or moves to four, the distribution of the 2018 dots will undoubtedly move up. 

▪ Four participants who previously projected three or fewer hikes would have to move to four hikes for the median to move up. That group, in our view, would have to include Powell and Quarles. ▪ Participants’ dots are submitted independently before the meeting, though they can be changed before the end of the meeting, with one caveat: Powell gets to peek before putting in his dot. We expect Quarles will be with Powell. So it will be up to Powell. 

▪ We expect the best outcome for Powell, ahead of his first press conference, is to deliver gentle policy:  participants’ median remains at three hikes, but they are now leaning toward four, reflecting the revision to the macro projections. 

▪ Sharp downward revisions to expectations of growth in Q1 following recent data might also hold one or two participants at three who otherwise might have moved to four. 

The Outlook Context 

Revisions to the macro projections for 2018 will be dominated by the progressive updating of the fiscal policy assumptions. The March FOMC projections will now fully incorporate the tax legislation and the budget agreement. The fiscal stimulus is large and comes at a point in the cycle where the economy is already growing at an above-trend rate, the unemployment rate is already below the NAIRU and likely to continue falling, and inflation is expected to move to 2% sooner rather than later. Fiscal stimulus will boost growth,  lower the unemployment rate further, and put upward pressure on inflation.  

The Forecast: A Prelude to the Dots 

2017 2018 2019 2020 Longer run
Change in real GDP 2.8 2.3 2.0 1.8
December projection 2.5 2.5 2.1 2.0 1.8
Unemployment rate 3.9 3.7 3.7 4.6
December projection 4.1 3.9 3.9 4.0 4.6
PCE inflation 2.0 2.0 2.0 2.0
December projection 1.7 1.9 2.0 2.0 2.0
Core PCE inflation 2.0 2.0 2.0
December projection 1.5 1.9 2.0 2.0
Memo: Projected appropriate  policy path
Federal funds rate 2.1 2.9 3.4 2.8
December projection 1.4 2.1 2.7 3.1 2.8

Sources: Federal Reserve, MPA. 

Stronger and Stronger, with a Hiccup Along the Way 

In the March projections, participants will for the first time fully incorporate both the tax legislation and the higher path of government spending from the Bipartisan Budget Act of 2018 (BBA 2018).1 The minutes of the January FOMC meeting noted that participants had revised up their estimates of the effect of the tax cut,  suggesting that the December projections incorporate a smaller effect than the March projections will. In addition, the December projections certainly assume less discretionary spending than the BBA 2018 implies.  The revisions to the fiscal assumptions since December call for a meaningful upward revision to 2018 growth on top of the four-tenths upward revision in December.  

Since December, we’ve revised up our forecast for 2018 from 2.4% to 2.8%, and we expect FOMC  participants to do the same. The upward revision, largely from the recent spending deal, would have been  larger, but there were several offsetting factors: 

1. Financial conditions have become marginally less accommodative since our January forecast, with equity prices lower and Treasury yields higher. We took a tenth off growth in 2018 to account for this. However,  equity prices are higher than at the time of the December FOMC meeting, so it’s unclear how FOMC  

1 An omnibus appropriations bill must be signed by March 23; otherwise, another continuing resolution must be passed or the government will shut down again. Lots of unfinished business, but we expect it will be agreed to by March 23.

participants will treat the fact that they have retreated from their highs. It’s certainly the case that  Treasury yields are significantly higher than in December, however. 

2. While we still see the economy as having strong momentum, we substantially lowered our forecast of Q1  growth, from near-3% to 2% in our recently updated forecast. That took off further from the 2018  number.  

3. Our projections take into account changes in fiscal policy as well as the monetary policy response. For us, that meant adding an additional rate hike in 2019. FOMC participants will also be adjusting upward their expected pace of rate hikes. Of course, FOMC participants are naturally reluctant to directly link monetary policy actions to fiscal policy changes, instead noting that fiscal policy is only one of the numerous shocks that can affect the outlook and hence the path of policy.  

A Lower and Lower Unemployment Rate 

The upward revision to projected 2018 growth in March will bring about a downward revision to the path of the unemployment rate. We thought participants were at least a bit conservative in their downward adjustment to the unemployment rate in December—only two tenths despite revising up growth eight tenths.  They might continue to be conservative. First, the unemployment rate has stabilized at 4.1% for the last five months. Second, participants may read the jump in the participation rate in February as confirming the hope,  held by at least some on the FOMC, that a hot labor market would pull workers back into the labor force and temper any decline in the unemployment rate. Still, we expect a downward revision in participants’ median projection for the unemployment rate by the end of 2020 by two tenths, to 3.7%. 

Inflation Firming, With Risks Now to the Upside 

The incoming data have continued to indicate that inflation is firming and moving closer to the near-2% trend that was observed before the softening in inflation that began in March 2017. True, the 12-month core PCE  inflation rate was still 1.5% in February, and likely to move to 1.6% in March based on the CPI and PPI data available for February. That’s up from a low of 1.3% in August 2017, but still well below its objective. But,  more importantly, the monthly readings have firmed in the last several months. This firming led us to revise up our 2018 forecast a tenth, to 2.0%, and we expect the median FOMC projection to do the same. The median projections for 2019 and 2020 are likely to remain at 2%, though in December six out of 16  projections had an overshoot in 2020. We have been expecting an overshoot of 2% in 2019 and 2020 for some time; in our recently completed forecast, we project an overshoot by about ¼ percentage point in both 2019 and 2020. 

Longer-term Estimates of the NAIRU and Potential Growth 

With respect to longer-term growth, the question is whether participants will now assume some small positive supply-side effects of the tax legislation. Studies with dynamic scoring all find some effect, though implying just a tenth or so higher growth over the next ten years. As a result, some policymakers could raise their estimates of longer-run growth. While we don’t expect the median projection for longer-run growth to be revised up from 1.8% at this meeting, we wouldn’t be surprised if it goes up by a tenth. 

The median projection for the unemployment rate in the longer run (a.k.a. the NAIRU) remained at 4.6% in  December, but it would have only taken one participant at 4.6% or higher in December submitting a projection of 4.5% or lower for the median to have moved down to 4.5%. We have attributed the downward trend in participants’ median estimate of the NAIRU to the interpretation that lower-than-expected inflation suggested more slack in the labor market than previously assumed. However, the median did not fall in December even following the recent unanticipated slowing in core inflation. Now that inflation is firming, that potential trigger may have gone away. On the other hand, some may interpret the failure to see a more definitive uptrend in wage inflation as warranting another small downward adjustment in their estimate of the NAIRU. Too close to call. 

A Financial Conditions Conundrum? 

The FOMC pushes, and financial markets shrug it off. Financial conditions have not tightened significantly since rate hikes began in December 2015. Longer-term Treasury yields have risen substantially since the  December meeting—the ten-year Treasury yield is up 50 basis points—and the S&P 500 briefly fell 10% from its high reached in late January, but it’s hard to argue that financial conditions are substantially tighter, if at all. The S&P 500 is up about 4% since the December meeting, and the dollar is down about 3%. 

FOMC Call 

A 25-basis-point hike at the March meeting is a foregone conclusion. The more important question at next week’s meeting is about the dots. Will the distribution of the 2018 dots move upward? We think so. But will the median 2018 dot move up from implying three hikes to four? We expect not.  

The Dots in 2018: Still Three, But A Close Call 

The first number we will look at is the median dot for 2018. We see the upward revision in the median projection for 2018 growth and the further downward revision in the path of the unemployment rate since  December, as surely moving up the distribution of the dots. The question is whether the median will dot will move from implying three hikes to four. (We addressed this question in some depth in a separate commentary:  Click here for our analysis.

In September, participants revised up their 2017 growth projection to near 2½%, reflecting the incoming data, but they did not revise their medium-term outlook, which remained at about 2%. In December, they revised up their growth projection for 2018 at almost ½ percentage point, to 2½% as well. But from June through December, the median dot continued to show three hikes in 2018. Now, in March, there will be another upward revision to 2018 growth. There would appear to be tension between a 2018 dot still implying three hikes after those successive positive revisions to the macro projections. That said, some participants might be reluctant to move from three to four as a result of the sharp downward revision to anticipated Q1  growth. 

At the press conference, the Chairman puts any changes in the dot plot in context by relating the changes in the rate projections to changes in the macro projections. Powell will have a story! While the median dot in  2018 still implies three hikes, the distribution has moved higher. So the dot plot message is really three or four this year—at three but leaning toward four hikes. In addition, we expect participants to revise up their dots for 2019, bringing the total back to three from (strangely) a bit above 2. That will reinforce the more hawkish tilt in the dot plot. We also think the dots for 2020 could be marked up, though we have less conviction about this than we do about the upward move in the 2019 dots. 

We are watching to what degree the median projected funds rate for 2019 or 2020 overshoots the median neutral rate. This is especially important because historically recessions have tended to follow overshoots of r-star. In December, participants’ median fund’s rate overshot the neutral rate by 37.5 basis points. In our forecast, the fund rate overshoots the upwardly-revised r-star by 50 basis points.  

Bottom line: An upward shift in the dots. 2018 median unchanged, however, despite distribution shifting  higher.

Will Participants Raise Their Estimate of r-star? 

We did—by 25 basis points—reflecting the empirical literature on the effect of a sustained increase in the deficit-to-income ratio on real rates (Click here for our commentary). While we don’t expect the median longer-run dot to rise just yet, we will watch to see if there is an upward movement in some of the participants’  longer-run dots. That is what we expect. In time, we expect participants will raise their estimate of the neutral rate. For example, Williams has speculated about revising his longer-run dot up by 25 basis points. Note,  however, that all this revision would likely do is bring his longer-run dot in line with the December median longer-run projection of 2¾%. Similarly, Dudley argued that “Right now we have buoyant financial conditions and fiscal stimulus. Of course, that could mean that the neutral federal funds rate is higher now than it was.” 

If the median estimate of r-star does rise, they would presumably raise the path of the fund’s rate more than would be suggested by the revisions to the projected paths of the unemployment rate and inflation alone. Not sure the FOMC is ready for this yet. 

Message in the Statement 

There are two developments since the last meeting that the Committee will likely reflect in the statement.  First, they learned that growth has moderated since their last projections and since the January meeting.  Second, they learned that core inflation has firmed. 

The Committee will want to acknowledge that growth appears to have slowed, but gently. We think they can  accomplish this by returning to characterizing the pace of increases in economic activity as “moderate,” rather  than “solid.” They might use language like the March 2017 statement, another instance when first-quarter growth appeared to have slowed markedly, but they did not want to suggest that this had affected their assessment of the medium-term growth outlook. They will also have to downgrade household spending,  which was previously described as “solid” as well. We think they’ll say it has “moderated.” Business fixed investment is a closer call. We expect it will advance at a decent clip in Q1, but it’s also true that recent data on core orders have been soft and equipment spending is likely to moderate substantially from its elevated pace. We think they could simply say business fixed investment, like household spending, has moderated.  Whatever they do, the continued upbeat language on the labor market will take the sting out of the revision to the language on growth. And the upward revisions to 2018 growth in the projections will reinforce this message. 

But the message should be unambiguous with respect to inflation, and this is the most important revision to the statement, that inflation is firming in line with expectations. The more important story now is not that  12-month core inflation is running below 2% at the moment, but that the monthly data suggest inflation has been firming, consistent with the small upward adjustment to the median 2018 projection that we expect.  

The Committee will refrain from mentioning fiscal policy in the statement.  

The Committee might want to be sure the discussion of economic activity in the statement is consistent with an expectation of strong growth ahead, notwithstanding the weaker first quarter. It can do so by dropping the “roughly” in its assessment of the balance of risks. 

We note that, at some point, there likely will be a substantial rewrite of portions of the statement. For  example, one portion that will require a change at some point is the one that reads, “the federal funds rate is  likely to remain, for some time, below levels that are expected to prevail in the longer run.” However, a  revision to some portion of the statement wouldn’t necessarily have important policy implications. In any case, we don’t expect anything in next week’s statement, but it could happen. 

The Statement 

Information received since the Federal Open Market Committee met in January December indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate solid rate. Job gains remained solid Gains in employment, household spending, and business fixed investment have been solid, and the unemployment rate has stayed low. Household spending and business fixed investment appear to have moderated. On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent. However, recent monthly readings have been firmer. Market-based measures of inflation compensation have increased in recent months but 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, and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the  Committee is monitoring inflation developments closely. 

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 1-1/2 percent to 1-3/4 percent. at 1-1/4 to 1-1/2  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. 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; Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Loretta J. Mester;  Jerome H. Powell; Randal K. Quarles; and John C. Williams.

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