Rethinking the Policy Path and Adding 2021

We recently changed our fund’s rate call. For a discussion of that and the macro context, please see our Macro  Views (link). We expect five more quarterly hikes in the fund’s rate, without a pause, until it reaches 3.125%,  slightly above participants’ median estimate of its neutral level (2.9%).  

▪ The clear mission at this point is to remove any remaining accommodation. The FOMC will, of course,  rate the fund’s rate target next week, and downside risks are unlikely to preclude a December hike.  ▪ Uncertainty about the estimate of the neutral rate doesn’t appear to be a consideration at this point.  The Committee seems fully prepared to use the median estimate of the neutral funds’ rate as its guidepost for removing accommodation. 

▪ We see slightly better than even odds that the FOMC leaves the “accommodative” language in the statement unchanged, given that even after the September hike the funds rate will still be clearly below most estimates of the neutral rate. However, strong hints from the August minutes suggest a  decent chance of removal despite December being a more natural timing. 

Whether, when, and why to pause is the next policy question.  

▪ At this point, the obvious direction for policy in the near term is removing accommodation. ▪ But the data and the forecast don’t suggest any urgency in moving beyond neutral to a restrictive posture. 

▪ We don’t expect a pause in our forecast. Instead, we show a continuation of the gradual pace of hikes through September 2019. Thereafter, our forecast has the fund’s rate target remaining constant until late in 2021, when we include a funds rate cut. 

▪ The September SEP will likely continue to show tightening in both 2019 (three hikes) and 2020 (one hike), and no rate cuts at all. 

The addition of 2021 to the SEP offers a glimpse into the FOMC’s views on stabilization. However, the 2021  projections will not include provocative features of our own forecast. 

▪ The decelerating trend in growth going into 2020 points to a considerable risk that growth will dip below the trend in 2021, if not sooner. 

▪ In that case, the unemployment rate would begin to edge higher. Indeed, in our forecast we project a  rise beginning later in 2020, adding up to a couple of tenths by the end of 2021. But we don’t think the  FOMC will project a meaningful rise. 

▪ With inflation still near 2%, the priority on sustaining the expansion and the risks posed by the zero bound might encourage a quicker turn to ease than otherwise. However, the September SEP dots for 2021 will not show a rate cut.  

The Outlook Context 

For a discussion of the full macro context, please see our Macro Views (link). 

The FOMC has consistently shown an implicit pause in 2019, with only three hikes projected for next year.  We expect the economy by mid-2019 to have slowed to a 2½% rate in the first half (still comfortably above trend), the unemployment rate to have fallen to 3½%, and inflation to be about 2%. With growth above trend, the unemployment rate still declining, and inflation set to move above 2%, the Committee might be prepared to hike a third time in September 2019, viewing a move to a slightly restrictive posture as insurance against overheating risk. 

Growth Peaking, Deceleration Around the Corner 

Q2 GDP growth was revised up, and we read the incoming data as warranting a modest upward revision to  Q3 growth, leaving projected 2018 growth up 0.2 pp to 3.2%. Participants have been more conservative than we have been on 2018 growth. At the time of their June projections, Q2 GDP had not yet been released,  and Q3 had not yet begun, so participants could well revise up their 2018 forecast slightly more than we have. However, we assume they will continue to be conservative and revise up 0.2 pp to 3.0%. 

There have been changes in the outlook since June. Financial conditions have become less accommodative,  thanks to a further appreciation of the dollar, while there appears to be more momentum in growth than anticipated. However, participants seem less inclined to extrapolate any revision in the near-term forecast driven by the data into the medium-term forecast, so we expect the median projection of participants to remain at 2.4% and 2.0% in 2019 and 2020 respectively. 

Flat Unemployment Rate After 2018 

In June, the FOMC projected that the unemployment rate would be 3.6% in the fourth quarter of 2018. That now looks low, so we expect they’ll mark that up a tenth. But we don’t think they’ll change the path after that. We expect them to keep the unemployment rate flat at 3.5% in 2019 and 2020. With a slightly higher unemployment rate in 2018:Q4, that would imply a slightly larger decline in the unemployment rate in 2019,  which would at least be more consistent with their projection of well-above-trend growth next year.  

A Downward Revision to Our Inflation Path 

The economy has been flirting with a 2% inflation rate. Participants have said that that they were not declaring victory, that is, that inflation had reached 2% on a sustainable basis. That sentiment might be reinforced in the months immediately ahead. We now expect core PCE inflation to be 1.9% in 2018, and the further rise in the dollar since our last forecast took a tenth off our inflation forecast in 2019 and 2020, leaving it at  2.1% and 2.2%, respectively. This is consistent with projections based on the empirical Phillips curve. We think the FOMC median is likely to stay at 2% for 2018 and 2.1% for 2019 and 2020. 

Extending the Forecast through 2021 

2021 is far away, with the confidence bands widening. Powell will downplay the forecast for 2021. We see the most likely outcome for 2021 is that growth will dip below trend and the unemployment rate will begin to edge higher as a result. That is why, in our forecast, we have a funds rate cut toward the end of  2021. 

Participants will be reluctant to convey the same conclusion because projecting a rise in the unemployment rate would be noteworthy. While an edging up in the unemployment rate toward the NAIRU might seem 

appropriate given how low the unemployment rate is expected to be at the end of 2020, a slowing in growth to a below-trend rate and a rising unemployment rate would be unwelcome news. We expect that the FOMC  median projection for core PCE inflation in 2021 will be 2.1%, though 2.2% is certainly possible. 

FOMC Call 

Go Directly to Neutral 

The September hike is a foregone conclusion. The Committee seems focused on moving the directory to neutral with no pause along the way. The fund’s rate would reach its longer-run neutral level (estimated to be 2.9%  as of June) in June 2019 with four hikes: September, December, March, and June. The longer-run dots are highly concentrated in the range of 2¾% to 3%, with the median at 2.9%. 

To be sure, there is uncertainty about that rate. Powell has emphasized that the Committee should not let the point estimates carry undue weight. Rather, the FOMC should let the data inform its judgment. We expect the Committee to continue to signal an implied pause in 2019 (three hikes) in their updated rate projections. 

Pause for Longer than Six Months 

If the FOMC does pause, the next question is for how long and under what conditions would they resume hiking. The case for pausing is at least twofold. First, there is a qualitative difference between removing  accommodation and moving to an outright restrictive position. Second, the argument for a pause is to allow the Committee to be informed by incoming data. But three months is not much time to gather information,  especially if the decision of whether or not to move into the restrictive territory is viewed as an especially important one.  

If a pause lasts as long as six months, it becomes more of an open question whether the Committee would resume hiking before inflation and the inflation forecast moved at least a bit higher. We expect that the  Committee, with the prospect of an extended pause, might prefer to take out a little insurance against an uncomfortable further rise in inflation by taking a small step into restrictive territory, given the very low unemployment rate. 

Could Adding 2021 Affects Rate Expectations for 2020? 

As participants extend their forecasts into 2021, they will have to decide whether to extrapolate the growth deceleration that began in 2019 and 2020. If they do, growth would dip below trend and the unemployment rate would begin to edge upward. This might motivate them to stop rate hikes sooner to lean against a  slowing in growth in 2021. 

Easing by 2021 

We see a reasonably high likelihood that the FOMC eases sometime in 2021. A slowdown to a below-trend rate with the unemployment rate beginning to edge higher is at least flashing yellow. So, given our forecast that the unemployment rate is beginning to rise and likely to rise further after 2021, we assume the FOMC  will begin to ease in 2021. However, the SEP median will not show this easing.  

Powell’s Press Conference 

Powell’s opening statement will adhere to the ideas he set forth in his Jackson Hole speech (link). He will lean on the new SEP to illustrate the broad contours of the consensus macro outlook and rate paths, although he will stress that, beyond the immediate path of gradual increases, the rate path is highly sensitive to incoming economic data and changes in financial conditions. He will continue to exhibit a strong resolve to do “whatever it takes” to control inflation if needed while emphasizing that the priority is to orchestrate a  soft landing.

The questions posed to Powell will be slightly trickier to answer.  

• Short-run neutral vs. longer-run neutral: Powell will be asked if he thinks short-run r-star will exceed long-run r-star, as Brainard argued. Although he has on occasion also used this distinction to explain policy, he is unlikely to endorse this theory outright as doing so would amount to decisively shifting to a more hawkish inclination for 2019. 

• Restrictive policy: The SEP-implied rate increases beyond neutral will therefore be presented as a  provisional projection of what optimal policy would resemble. However, he is unlikely to declare that restrictive policy is necessary sooner rather than later based on the current outlook, a point Evans and  Rosengren have made in recent remarks.  

• EM stress: Powell will continue to note that the FOMC is monitoring international developments and that stresses from EM remain contained.  

• Politics: Powell will deflect direct questions about political outcomes and how they would affect the  FOMC’s forecast and rate path.  

• Trade: Developments in trade negotiations have become a routine topic at FOMC meetings. But Powell  will refrain from commenting directly on trade policy as in his view it is not the province of the Fed.  An exception would be if the trade is one of the factors already affecting the data and the outlook. 

• Accommodative wording: The September hike will bring the funds rate to 2.125%, which is still accommodative, or below the central tendency range for the longer-run rate of 2.75% to 3%. If the wording stays, as we expect, its inclusion might be interpreted as hawkish, implying a higher endpoint of rate hikes. Conversely, if the wording is omitted, then the market is likely to read it as a signal that the end of the hiking cycle is getting closer. Powell might push back against either outcome in his opening remarks, and he is sure to respond to questions by pointing to the macro outlook and the dots as a source of guidance. 

Powell will appear on Capitol Hill the day following the press conference to offer brief remarks on the U.S.  economy before an event hosted by a Democratic senator.  

The Dots  

A few policymakers have expressed more hawkishness about medium-term rate policy, and there are also compositional effects from the addition of Clarida and the movement of Williams from San Francisco from  New York.  

• 2018: Additional policymakers will move up their dots from three hikes to four, which strengthens the consensus for four hikes (implying a December hike). 

• 2019: The median will remain at three hikes. More policymakers will join the consensus at three hikes.  The median is unlikely to shift up to four hikes. 

• 2020: The median dot will continue to show some additional tightening beyond 2019, as in the June  SEP.  

• 2021: Projections for 2021 will be published for the first time in September. The likely outcome for the median is a flat funds rate from 2020 to 2021 or perhaps a slight tightening. A rate cut implied by the median would send a pessimistic message and is therefore unlikely. However, individual dots might show rate cuts. 

• Longer Run: The median is likely to stay within the 2.75% to 3% range. The median is sensitive to additional policymakers as the median in June was in between two levels. 

The Statement 

The data since the August meeting has almost certainly been stronger than the Committee expected,  warranting a modest upgrade of the growth outlook in the first paragraph. We don’t see any change to the language on the labor market or inflation.

We see the Committee as viewing the dots as providing the best forward guidance. So the Committee will be reluctant to add any forward guidance beyond the expectation of gradual rate hikes ahead. 

The policy will remain accommodative even after the September hike. The FOMC agrees that it should remove accommodation and that is what they will continue to say. The signal that would be sent at this point if  “accommodative” were omitted would be awkward. Powell will be asked at the press conference if policy remains accommodative, and he would have to answer yes and then explain why it was taken out of the statement. The wording will probably change in December (when the fund’s rate will rise to 2.375%). March  will be in the “range of neutral.” The wording will probably remain unchanged this week, but we see a  substantial chance that the FOMC opts to change the wording as soon as next week.  

International risks will be addressed in Powell’s press conference, so there is no reason to mention anything about this in the statement. Nevertheless, it is possible that the September statement provides some color to  the balance of risks with wording such as “taking into account domestic and international developments.”  Such an inclusion would be dovish.  

Our Guess of the Statement 

Information received since the Federal Open Market Committee met in June 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 stayed low. Household spending and business fixed investment have grown strongly. 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. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that further gradual increases in the target range for the federal funds rate 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. 

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1-3/4 to 2 percent. raise the target range for the federal funds rate to 2 to 2-1/4 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 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; Esther L. George; Loretta  J. Mester; and Randal K. Quarles.

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