The Balance of Risks is Shifting to the Upside

Three features of the outlook are driving monetary policy. 

▪ The unemployment rate is already well below the NAIRU. We expect it to fall further, to almost a  percentage point below the NAIRU. 

▪ Inflation is firming and the data should soon be consistent with participants’ expectation that it will head toward 2% this year. 

▪ Financial conditions remain very accommodative and have resisted the FOMC’s attempt to withdraw monetary accommodation. 

The balance of risks for both growth and inflation is shifting to the upside. 

▪ We see building momentum in aggregate demand now being reinforced by tax cuts and accommodative financial conditions, with an uncertain amount of additional stimulus likely to result from budget negotiations. This suggests upside risks to growth remain, even though FOMC participants have repeatedly revised up their projections. 

▪ With the unemployment already below the NAIRU, the balance of risks for growth suggests downside risks to the FOMC’s unemployment rate projections and upside risks to the FOMC’s projection that inflation will rise to but stabilize at 2%.  

The FOMC median projection in December 2017 was for three hikes in 2018. We see the consensus today being three to four, not two to three. By June, we expect to see the consensus converge to four hikes.  

▪ FOMC participants will see a rate hike in March 2018 as especially important, given the expectation of three or four hikes this year.  

▪ We expect that the projection of a fourth hike in 2018, if adopted, would leave the fund’s rate ½  percentage point above the estimated neutral in 2020, in line with our forecast. 

The Committee wants to balance the risks but does not see much risk of a serious overshoot of core inflation.  

▪ We suspect that it wants a funds rate path that would stabilize the unemployment rate at 3½% or above. ▪ Given the flatness of the Phillips curve and given that long-term inflation expectations are not likely to move above 2% because of a modest overshoot, inflation is unlikely to move more than a ¼ percentage point above the 2% objective. 

▪ We expect that sometime this year the median projection for inflation will move above 2% for 2020, if  not 2019. 

▪ The FOMC will be emphasizing a symmetric inflation objective, again and again, this year, with the message being that it would not be unhappy with, and might warmly welcome, a modest overshoot. That would signal that it is an asymmetric inflation objective in practice, not only in words. 

The Outlook Context 

The economy gained momentum in the second half of 2017, and the strength will spill over into this year.  The still-very-accommodative financial conditions and additional fiscal stimulus will reinforce this momentum.  That is reflected in participants’ December projections and our updated forecast. In our forecast, we see well above-trend growth this year and modestly above trend growth next year, along with a further decline in the unemployment rate to about one percentage point below the NAIRU. While inflation has continued to run soft, we see some signs of firming, and participants are likely becoming more confident in their projection of  near-2% this year and 2% the following two years. We see the unemployment rate far enough below the  NAIRU to result in an overshoot of the 2% objective in 2019 and 2020. The balance of risks for growth has now shifted to the upside, which, in turn, is increasing concern about falling behind the curve. As a result,  there is more concern that inflation will overshoot, rather than undershoot, the 2% objective over the next couple of years. 

Lots of Momentum 

There is a lot of momentum into 2018, some of which reflects the anticipation of fiscal stimulus, and the fulfillment of fiscal stimulus will reinforce that. Growth is also being driven by still-very-accommodative financial conditions, more so than might be expected at this point in a tightening cycle. Growth was well above trend last year, and both we and participants expect that this will also be the case this year, followed by a slowing toward trend growth by 2020. In the meantime, the unemployment rate will continue to decline,  and, in our view, to further below the NAIRU than in participants’ December projections. And the balance of risks to growth appears to be shifting to the upside. 

Inflation Firming, Poised to Overshoot 

Participants have basically ignored the slowing of core inflation in 2017 in their projections for this year and the next two years–testimony to their confidence that the slowdown is transitory! The concern is building that the FOMC is getting, or may already be, behind the curve. Indeed, we have emphasized the inconsistency in participants’ December projections. As the unemployment rate has fallen further and projections have also been marked down–to a low of six tenths below the NAIRU in the December projections, the median inflation projection has remained unchanged, at, you guessed it, the FOMC’s objective. If the unemployment rate falls further than they now expect, and inflation moves back to near 2% this year, the Committee will likely raise its projection to above 2%. 

Financial Conditions: More and More Accommodative 

The FOMC is being pushed to raise rates faster than otherwise by the still-very-accommodative financial conditions. The ten-year yield has risen, but that has been offset by a narrowing in spreads on corporate bond yields. Equities continue to climb, and the dollar is actually declining. This is an important consideration, also driving the FOMC to raise rates faster and perhaps further above neutral than otherwise. 

FOMC Call 

Obviously, no hike next week, but Committee members will leave the meeting firmly expecting to go in March,  absent significant surprises. We have been expecting a March hike, which would also make it more comfortable if they want to raise rates four times this year. At this point, participants disagree about the number of hikes this year, mostly between two and four. While the median, if taken today, would still be three, we see the consensus as three to four, not two to three, and we expect the median dots to reflect four moves this year by June. As for our baseline forecast, we expect four hikes this year, three next year,  and one more in 2020, leaving the fund’s rate ½ percentage point above the estimated neutral rate. In their  December rate projections, participants also moved their rate projections to above neutral by 2020, though only by ¼ percentage point. The concern is building about falling behind the curve, a shift in the balance of risks toward higher inflation, and stronger growth. In addition, still-very-accommodative financial conditions and financial stability concerns are pushing in this direction as well. But we expect the flat Phillips curve and 

well-anchored inflation expectations will limit the inflation overshoot and lead to a much more restrained overshoot than experienced in recent cycles. 

Shifting Balance of Risks 

What is changing within the Committee is that there is less emphasis on the modal outlook and more emphasis on the balance of risks. And a risk management approach cautions the Committee to take into account the balance of risks as well as the modal forecast. Financial conditions and fiscal stimulus are not just being  reflected in the modal forecast, but also in a growing sense that the balance of risks for inflation has shifted, 

from remaining below the 2% objective longer than expected to overshoot the objective. And while projections have shifted up to take into account the tax legislation, we expect we–and perhaps they–have underestimated the degree of stimulus to come from budget negotiations. For now, that means to keep going and not to pause this year, absent adverse shocks. 

Symmetric, Symmetric…Did You Hear Me Say Symmetric?! 

While the balance of risks may be shifting, the resultant anxiety is tempered by the expectation that–given the flat Phillips curve and inflation expectations unlikely to move above 2%–any overshoot in inflation will be quite modest. In the spirit of a symmetric inflation objective, it would be welcome news. Indeed, Evans has emphasized that overshooting is the only way to convince markets that the Committee really has a symmetric inflation objective. More significantly, centrists on the FOMC have increasingly made that point. For example,  Dudley has said: “Let me be clear: A small and transitory overshoot of 2 percent inflation would not be a  problem. Were it to occur, it would demonstrate that our inflation target is symmetric, and it would help keep  inflation expectations well-anchored around our longer-run objective.” 

So, we expect that we will hear the word “symmetric” again and again, to emphasize that inflation is likely to modestly overshoot the 2% objective. 

Reviewing the Statement on Longer-run Goals and Monetary Policy Strategy 

The Statement on Longer-Run Goals and Monetary Policy Strategy is released either with the January FOMC  statement if there are substantive revisions (as in 2016), or with the January FOMC minutes, if there are no substantive revisions (as in 2017). We don’t expect any changes to this strategy statement this year, except to update the NAIRU estimate to reflect the most recent projection (4.6%, from 4.8%).  

Message in the Statement 

Markets are already assigning a high probability to a March hike. The FOMC doesn’t want to lean against this, but there is also no need to reinforce that expectation. The key language in the first two paragraphs concerns inflation, both the data and the outlook. Works fine. We see some firming in the data, but it is too soon to show more confidence about reaching 2% in the next year or two. In any case, the December projections tell that story. 

The time may be approaching to reassess the language on the balance of risks. The balance of risks looks tilted to the upside in each case. We expect many on the Committee agree. But this is a big step and would have a big market impact. Not yet. 

Of course, the statement will also be modified to reflect that there will be no change in the fund’s rate target at this meeting. 


Information received since the Federal Open Market Committee met in November December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate.  Averaging through hurricane-related fluctuations, job gains have been solid, and the unemployment rate declined further remained low. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, both overall inflation and inflation for items other than food and energy have declined this year over the past year and are running below 2 percent. Market-based measures of inflation compensation have moved up 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. Hurricane-related disruptions and rebuilding have affected economic activity, employment, and inflation in recent months but have not materially altered the outlook for the national economy.  Consequently, The Committee continues to expect that, with 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 remain somewhat below 2 percent in the near term but 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 the target range for the federal funds rate to maintain the target range for the federal funds rate 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 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 Janet L. Yellen, Chair; William C. Dudley, Vice Chairman;  Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Patrick Harker; Robert S. Kaplan; Loretta J. Mester;  Jerome H. Powell; and Randal K. Quarles; and John C. Williams. Voting against the action were Charles L. Evans and Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.

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