FOMC Meeting: The Dot Plot Thickens

With stronger growth and tax cuts in mind, the FOMC hikes rates and adjusts its forecasts.

In line with expectations, the Federal Reserve raised short-term rates by 25 basis points today to a range of 1.50%-1.75%. In the run-up to the meeting, futures markets had set the chance of an increase at 97%, and Fed Chairman Jerome Powell and various colleagues reinforced that confidence with hawkish comments to legislatures and the public. Those sentiments were echoed in the committee’s press release, which cited strong job gains, low unemployment and moderate improvement in the economy as supporting the increase.

This is the first rate hike of Powell’s brief tenure, and comes at the time when the FOMC finally has a more complete picture of fiscal stimulus and its potential impact on the economy. It also comes on the heels of truly impressive GDP numbers for the second half of 2017. Various headwinds of 2014-16 including a “profit recession” and economic weakness in emerging markets tied to a then-strong U.S. dollar are a thing of the past. Perhaps the most significant turnabout is in the jobs market: In the three months through February, an average of 242,000 U.S. jobs were created each month compared to an average of 167,000 created in the three months ended in November. All the while, the Fed has continued to press gently on the brakes via steady rate hikes and a slow removal of quantitative easing.

How Many Rate Hikes?

Recent market tension has focused on how many   increases we will see this year. Powell sounded fairly hawkish before Congress last month, as did a number of his FOMC colleagues in their public statements. However, he took more of a middle ground in his press conference today, perhaps to maintain optionality on rates going forward. Individual FOMC members’ projections for short rates (the Fed’s dot plot) remained static for 2018 at 2.1%, but increased to 2.9% in 2019 (versus 2.7% in December), and 3.4% in 2020 (versus 3.1% in December).

Given that Powell is new and likely doesn’t want to jar the markets too quickly, we believe that the committee will come through with a total of three increases in 2018, barring unusual circumstances (though nearly half of FOMC members would like to see four increases), and then probably go with another three in 2019. The task will be to maintain a balance between overheating of the economy, especially as we received fiscal stimulus when the economy was already operating at potential, and restoring inflation to the symmetric target of 2%. Look for some overheating of the economy to bring inflation to that target before the steeper path of the dots pulls conditions back into line.

On inflation, the FOMC has started the journey but hasn’t yet arrived. In January, core personal consumption expenditures (PCE, the Fed’s preferred metric) was just 1.5% (year-over-year), although the six-month annualized trend has reached 2.0% as the economy has accelerated. Similarly, core CPI is up 1.8% YoY but a more robust 2.6% over six months.

A Move Away From Secular Stagnation?

It’s important to keep in mind that the narrative throughout the Yellen era was one of secular stagnation. When the FOMC first started sharing individual members’ forecasts in 2012, the mean terminal (or peak) fed funds rate was around 4%. As their view of economic potential dwindled, that figure drifted down to 2.8% in December and has just inched up to 2.9%. Whether that general decline can be reversed is a key question, but there are positive signs. After years of excess regulation suppressing the economy’s “animal spirits,” tax cuts and a pullback on those rules are having a clear impact. For example, the NBIF survey shows that optimism of small business owners has reached an all-time high, with positive implications for expansion and further hiring, while consumer sentiment is also quite robust. As we assess whether the Trump “experiment” can bolster productivity, we’ll look for clues in the degree to which the stimulus accelerates capital expenditures over the coming months. Overall, the winds are shifting and the dots are in motion, rotating upward in line with the movement of long-term interest rates so far this year. 

On a final note, today’s meeting is notable for pushing the real fed funds rate (the nominal rate minus inflation) into positive territory for the first time in a decade. The impact of that transition shouldn’t be underestimated and introduces new variables to the macroeconomic environment—most obviously an increased level of volatility for both equities and bonds. As the real fed funds rate becomes normalized, we should expect more turbulence and an eventual (and intentional) slowdown in economic growth.

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