The opportunistic Fed
21 March 2017
As expected, FOMC members voted to lift the target range for the federal funds rate by 25 basis points at last week’s meeting to 0.75-1%. Given how well-signalled the hike was we were mainly focused on the communication surrounding the decision, and what it implied about the future path for policy. The market interpretation of the meeting was that the Fed delivered a dovish hike. The median dot in the Committee's end-year interest-rate projections was unchanged in 2017 and 2018, as was its assessment of the long-run neutral rate (see Chart 2). There were also only fractional changes to members' forecast for GDP growth, unemployment and core PCE inflation, though their implicit forecast for the NAIRU edged down (see Chart 3). Yellen's press conference was also noteworthy for her avoidance of hawkish language and emphasis on the need for inflation to be sustained at the 2% target before the inflation side of the Fed's mandate will have been met. Meanwhile, officials gave little indication that they are in a rush to begin normalising the balance sheet, though we do think that will come up for more consideration by the end of the year if rate normalisation continues.
Yet, the decision to lift rates in March raises an important question. If the view on the macro outlook was more or less unchanged, and core members of the Committee are not prejudging how government fiscal policy might evolve, why did four of the members who had considered two rate hikes appropriate back in December, including Yellen herself if our identification of her 'dot' is accurate, decide that three hikes this year was now appropriate? We think there are two main explanations for the shift. The first recognises that central bankers' policy views are endogenous to their economic forecasts. In the absence of the hike, Yellen's near-term growth and inflation forecasts would likely have increased by a bit more than she was comfortable with. In other words, she had concluded that policy was more accommodative than was necessary to meet the Fed's objectives. A complementary explanation is that Fed officials were being opportunistic. The domestic and external economic backdrop is currently very favourable, risk assets have been buoyant despite the recommencement of normalisation, and fiscal policy is more likely to loosen than tighten over the coming year, even if the scale and scope is still uncertain. Waiting would have risked the window closing and the Fed falling a bit behind the curve. Getting rates up a little faster has the added benefit of giving it slightly more room to ease if things go wrong.
What next then for policy? The meeting did not alter our outlook. We still expect two more rate hikes this year, with the first of those delivered in June if the economic, market and political environment remains supportive. Three more hikes are possible, but only if indicators of inflation pressures surprise to the upside or fiscal stimulus is delivered well before the end of the year. We don't expect the Fed to cease reinvesting the proceeds of its maturing bonds until 2018 and anticipate that when it does come, it will be mechanical and predictable. We also see little reason to change our view that the neutral Fed funds rate is rising only gradually and that it won't end the cycle much above 3%.
Jeremy Lawson, Chief Economist