Fed Holds Rates Steady

With incoming data largely supporting the Fed’s economic outlook, central bankers did as expected and left policy rates unchanged. There is little reason to expect the Fed to alter course from the predicted three or four rate hikes this year (barring any slowdown in the data or increase in risks to the outlook, four should be the baseline). The most important news from the FOMC statement was the hint that the Fed would not overreact with substantial policy changes in response to inflation readings modestly above 2 percent. As usual, watch the employment report for signal that the economy will overshoot full employment, but also note that the Fed already expected overshooting.

The Fed concluded their two-day meeting with a statement that was largely unchanged with the exception of updates in response to incoming data. Most notable was the addition of “symmetric” in this line:

Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.

Inflation is now very near the Fed’s target and it is reasonable to expect some overshooting of that target. Central bankers are reminding market participants that the inflation target is symmetric such that they will tolerate reasonable short-run deviations from target in the near term. In other words, don’t freak out if inflation exceeds 2 percent as that alone will not drive the Fed to change policy. The Fed is likely to stick to the present policy path unless inflation rises above 2.5 percent and looks like to stay high without a more aggressive policy stance.

The next major release is Friday’s employment report for April. Expect payroll growth to bounce back from a weak March reading; my forecast of a 207k gain is fairly close to the Wall Street consensus of a 190k gain. Job growth running at roughly 200k per month should eventually put downward pressure on unemployment. Or at least this is what the Fed expects as they foresee unemployment falling to a low of 3.6 percent by the end of next year.

That said, unemployment has remained stuck at 4.1 percent for months. This is good news as the labor market keeps kicking out supply to meet demand. The Fed fears this good news will eventually come to an end as the demographics factors eventually catch up to the cyclical forces pulling people into the labor market. Note that this is already build into the Fed forecast, so if it happens soon it should not dramatically alter the path of policy.

Likewise, tepid wage growth belies claims that the economy has surpassed full employment. If wage growth remains low, the Fed will likely continue their downward revisions of their estimates of the natural rate of unemployment. Faster wage growth would reinforce their current views, but again this is already build into the forecast.

Bottom Line: The Fed’s forecast already calls for faster inflation and some overshooting of the full employment objective. This is why central bankers anticipate that interest rates will need to rise above longer-term levels; returning the economy to a sustainably longer run equilibrium requires such tighter monetary conditions in their models. What gets us to a faster pace of rate hikes? Clear evidence that the economy has surpassed full employment in the form of sharply higher wage growth plus either much quicker than expected unemployment declines or evidence that inflation will be sustainably above 2.5 percent. Of course, also watch for the possibility that the Fed foregoes a fourth rate hike this year if the economic activity unexpectedly wanes.