Stronger Growth, Unchanged Inflation, Clearer Funds Rate Overshoot

Overall, the December FOMC statement as well as macro and funds rate projections were broadly consistent with our expectations, and Yellen’s press briefing didn’t include any surprises. 

The first paragraph of the statement remained upbeat about economic activity and the labor market. ▪ They noted that labor markets “continued to strengthen,” and economic activity was characterized as  “solid despite hurricane-related disruptions.” 

▪ As expected, rather than commenting on monthly movements in prices, as had been done in the November  statement, the FOMC returned to language similar to that in the September statement: “On a 12-month  basis, both overall inflation and inflation for items other than food and energy have declined this year and  are running below 2 percent.” 

▪ As expected, both Presidents Evans and Kashkari dissented. 

The most interesting changes in the statement were changes to the forward-looking language on the labor market, in the second and third paragraphs. 

▪ Previously, the statement had referred to an expectation of further improvement in the labor market (“will  strengthen somewhat further” and “some further strengthening”); now it notes an expectation that labor  markets will remain “strong.” 

▪ Chair Yellen commented specifically on this change in her press briefing. She explained that while the  FOMC expected some further strengthening in the months ahead, the pace of job gains was expected to moderate over time in response to the gradual removal of monetary accommodation. 

▪ We don’t see the new language as reflecting any change in policy inclinations; however, the FOMC is communicating that it does not expect—and is not seeking—declines in the unemployment rate of the magnitude experienced over the past year or so. The emphasis is on the stabilization of the unemployment rate over 2018-2020 at a level consistent with maintaining a strong labor market. 

The macro projections were also broadly as expected: stronger growth, lower unemployment rate, and core inflation at its objective by 2019. We fully expected that growth would be revised up and the unemployment rate would be revised down. In our view, the most important question was whether they would revise down their inflation projections. 

▪ In the event, the projections for core PCE inflation were unchanged: 1.9%, 2.0%, and 2.0% in 2018,  2019, and 2020, respectively.  

▪ We have emphasized the information content of the core inflation projection for 2018. Apparently,  participants continue to see the recent slowing in core inflation as temporary and hence have not changed their expectations for inflation next year or thereafter. 

Yellen noted that the upward revision to growth in 2018 was due in large part to the inclusion of tax legislation  in the projections of “almost all participants.” 

▪ We’d expected the FOMC to mark up its growth projections, but the extent of the upward revisions was surprising—a cumulative eight tenths on the level of real GDP by the end of 2020. Growth in 2018 alone was marked up four-tenths, to 2.5%.  

▪ Chair Yellen remarked in her press conference that “most, almost all participants [are] now factoring in  their assessment of the impact of the tax policy.” She pointed out that some participants were already incorporating stimulus in September. All told, more fiscal stimulus, easier financial conditions, and stronger-than-expected momentum explain the upward revisions. 

As expected, the path of the unemployment rate was lowered in response to its recent decline as well as stronger projected growth, but the downward revision was smaller than would have been expected given the revisions to output. 

▪ The projected path of the unemployment rate was releveled down by two tenths: 3.9% in 2018 and  2019, edging up to 4.0% in 2020. 

▪ But the eight-tenths upward revision to the level of real GDP relative to their September projections would have been expected to lower the unemployment rate by 3 to 4 tenths according to a conventional Okun’s  Law. So we would have thought that their unemployment rate path would have been closer to our forecast of 3.7% by the end of 2019. 

▪ In addition, we were puzzled by the fact that the projected unemployment rate rises, though just a tenth,  to 4% in 2020. Why the increase, when growth is expected to remain modestly above-trend that year?  ▪ Furthermore, the inflation projections weren’t revised up. Yellen was asked to explain why inflation wasn’t revised up when growth was revised up and the unemployment rate down. She could have said that’s a  reflection of how flat the Phillips curve is. But she had to reach somewhat for an explanation.  ▪ She said such inconsistencies sometimes arise when many projections, for several variables, are being reduced to medians. She added, “inflation has run lower than we expected, and it could take a longer  period of a very strong labor market in order to achieve the inflation objective.” 

▪ She didn’t change her story on the explanation for the slowdown in inflation this year: FOMC participants  continue to expect that the factors responsible are “likely to prove transitory.” 

▪ However, she acknowledged that, although it is not the FOMC’s base case, one possibility is that the  inflation shortfall “could end up being something that is more ingrained and turns out to be permanent.”  ▪ She said that “it’s not my judgment that inflation expectations have slipped, but that also remains a  possibility that needs to be monitored.” 

As expected, for 2018 the median projected number of funds rate hikes remained at three. An additional projected hike in 2020 brings the median rate path quite close to our recent Macro Views forecast. ▪ For 2018, while the median number of hikes projected remained at three, slightly more participants were now below the median than above in September. However, voter composition has also changed since September. 

▪ For 2019, while the median number of hikes projected relative to September remained unchanged (three),  the mean increased slightly.  

▪ The median dots imply an additional hike in 2020 (in Yellen’s words, “a touch higher”). As a result, there is now a clear overshoot of the neutral rate in 2020, to 3-3.25%. 

▪ As we’ve argued, an overshoot of the neutral rate is logical, given that inflation is projected to reach its objective with the unemployment rate still substantially below the NAIRU. 

▪ The median longer-run dot remained at 2.75%, but the distribution around that dot shifted upward slightly,  as there were fewer projections below the median. 

Although the FOMC, like we, now project a funds rate overshoot, our projected fund’s rate path differs somewhat from the FOMC’s: the hikes in our forecast are slightly more front-loaded, and the overshoot is slightly larger.

▪ Relative to the FOMC’s dots, we expect one additional hike each in 2018 and 2019, but one fewer hike  in 2020. 

▪ Our faster pace of rate hikes relative to the FOMC is easy to justify, given the differences in our macro projections. We expect above-trend growth to result in a drop in the unemployment rate that is two-tenths lower than that of the participants. Consistent with that, we have core inflation overshooting its objective modestly in 2019 and 2020. 

Yellen commented on the recent debate about the implications of the flattening of the yield curve. Her comments here were consistent with what we have written about the implications of a lower term premium for the shape of the yield curve. 

▪ She emphasized that “structurally,” the yield curve is likely to be flatter and remain so given that the term premium is estimated to have declined as inflation risk has become less of a concern. ▪ She said the term premium is “quite low, close to zero” today.  

▪ A lower term premium means a flatter yield curve on average and a greater likelihood of an inverted yield curve even with a modest overshoot of the neutral fund’s rate. 

▪ She concurred with the market consensus that there are currently low odds of recession.  

                                             Table 1 

FOMC Participants’ Projections for the Year-End Level of the Target Funds Rate 

                                                                                                                                                                                                     

Source: LH Meyer and Federal Reserve. Updated December 13, 2017. 

                                 Table 2 

Median of Projections of FOMC Participants 

Source: LH Meyer and Federal Reserve. 

Projections of inflation and growth in the real gross domestic product (GDP) are for periods from the fourth quarter of the previous year to the fourth quarter of the year indicated. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.

*LH Meyer forecast published December 7, 2017. 

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