The Federal Open Market Committee (FOMC) completed their June meeting with a 25 basis point rate hike, bringing the target range for the federal funds rate to 1.75-2.0 percent. The accompanying Summary of Economic Projections (SEP) revealed a modestly more optimistic outlook, as expected. The improving outlook prompted an upward revision to rate hike expectations with the median policymaker anticipating four rate hikes this year, up from three in March. The Fed dropped the explicit forward guidance language in the statement as they work to encourage market participants to undertake a more nuanced, data-driven approach to assessing the future path of rate hikes.
With the economy chugging along at a respectable clip that could exceed 4 percent in the second quarter, the Federal Reserve upgraded its assessment of growth from “moderate” to “solid.” Expected growth for 2018 as a whole rose from 2.7 to 2.8 percent while the unemployment forecast fell from 3.8 percent to 3.6 percent. If history is any guide, that forecast remains too pessimistic given the expected pace of growth this year.
The longer run estimate for unemployment held at 4.5 percent, but the upper end of the central tendency dipped from 4.7 to 4.6 percent. Assuming no significant uptick of inflation, I expect the longer-run unemployment estimate to fall if the actual unemployment falls faster than the Fed expects.
Inflation projections edged up for 2018, but expectations for core-inflation for 2019 and 2020 remained unchanged at 2.1 percent. Essentially, the forecasts imply that a slight bump in the expected pace of rate hikes from three to four rate hikes this year is sufficient to contain the inflationary implications of the modestly better economic forecasts.
To be sure, the Fed’s expectation that they will deliver a full four rate hikes this year should not come as a surprise. Indeed, I would argue that the two low dots in the March SEP were effectively irrelevant for the likely path of policy and eliminating those dots would shift the median projection to four rate hikes. In other words, the median policy maker was already so close to four hikes for 2018 that the bar to making it official this month was very, very low.
The median policy maker anticipates another three rate hikes in 2019. Policy makers also expect they will still raise rates to an above neutral 3.4 percent in 2020 while the longer-run neutral rate held at 2.9 percent. Any “hawkishness” in this SEP reflects the slight acceleration in the pace of hikes; the end game, however, remains unchanged.
The Fed continues to describe policy as accommodative, but dropped language indicating that policy would “remain, for some time,” accommodative. This needed to change given that the lowest estimate of neutral sits at just 2.3 percent, the Fed could be pretty close to neutral with just one more hike. Eventually too they will drop the description of policy as accommodative as rates move closer to the median estimate of neutral.
As policy edges closer to neutral, the exact timing of future rates hikes will become more data dependent. That said, make no mistake that the Fed continues to signal that rates will continue to rise at a pace of roughly 25 basis points per quarter given the expected pace of growth. I would not underestimate the Fed’s resolve in this matter. I expect this pace to hold for the next four quarters if the Fed’s forecast continues to be realized.
Bottom Line: Pay attention to the interplay of the rate and economic forecasts and the flow of data. The pace of data will almost certainly not slow sufficiently to prevent the Fed from hiking in September and probably December. I would say September is essentially a lock at this point. I also think you need to pencil in rate hikes in March and June of 2019. Recognize though that by mid-2019 the data might reflect the lagged impact of past tightening and the yield curve is likely to be fairly flat; both factors would slow the pace of rate hikes. The Fed will face a more difficult choice if the data holds strong while the yield curve inverts.