The Federal Reserve’s recent decision to raise rates again by 25 bp to the range of 1.75%-2% did not come as a surprise. However, the Jerome Powell’s press conference, the Fed’s press release statement, the dot plot and economic outlook provided some insight into what Fed members are thinking. Here are my main takeaways:
- The economic outlook shows a more hawkish Fed: The economic outlook did not show many changes from the March meeting outlook. However, the Fed’s outlook of GDP growth remains anchored at 1.8% for the long run, which means the recent fiscal policy boost – in the form of tax cuts – didn’t persuade its members to raise their GDP growth projections. The same goes for inflation or long-run unemployment rate.
- The long-term unemployment rate does not make much sense, disregard it? Powell seems to agree: The Fed’s nairu is still set at 4.5% — above the current rate of unemployment. This does not make much sense for me and perhaps even for Chairman Powell, who also referred to this issue in the press conference by downplaying the importance/relevance/accuracy of this figure. Based on my calculations, considering a simple reaction function that accounts for the central economic forecasts, the Fed should have risen rates by now to 3%, given their short-term and long-term outlook! This result is mostly because of the Fed’s high nairu given the currently low unemployment rate and short-term projections. Moreover, what could bring up the unemployment rate up back to 4.5% short of an economic slowdown or even recession – which would also force the Fed to raise rates and cut GDP growth rate? Does it mean the Fed aims to cool down the economy so that jobs are destroyed at a faster pace than they are created to bring the unemployment rate back to their nairu?! Again, this projection does not seem right. However, perhaps the takeaway is that Powell is also not paying too much attention to this figure and so shouldn’t we. If so, perhaps we will see the Fed moving away from the Philips curve theory when it comes figuring the relationship between inflation and employment.
- The Fed’s long-term cash rate does not make much sense either: Like in point 2, the long run rate is lower than the Fed’s expected rate in 2019 and 2020. Given the current subdued inflationary pressures, slow growth in wages and expected low inflation in the coming years, this outlook does not make much sense either.
- The dot plot shows more hikes to come, but will they arrive? The dot plot showed two more hikes are expected this year and another three hikes in 2019 (one more than previously expected for each year). Given the above, I remain doubtful the Fed will push rates at this pace. Sure, this year’s two more hikes are baked in and unless a trade war erupts – which seems more likely every passing day – the Fed is not likely to change course. However, for next year, I think things will be different, and the Fed will likely want to slow down its rate hike pace. After all, the yield curve is very flat and likely to invert in the coming months. The economic instability in emerging markets as the Fed raises rates and the dollar gains strength could also leak back to the U.S. And keep in mind the rise in U.S. debt along with the slow decline in the Fed’s balance sheet could actually drive up treasury bond yields — this could also ease the Fed’s eagerness to raise rates. Finally, the uncertainty around trade could become a growing concern in the markets. All these factors are likely to be felt by next year if not sooner.