FOMC comment: Shaping market expectations for a December rate hike
The Federal Open Market Committee (FOMC) increased the target range for the federal funds rate by 25 basis points to 2–2.25 percent on Sept. 26 and took the next step in preparing the market for a December rate hike. This is in line with Fed rhetoric and the implied path of monetary policy embedded in the dot plots and the summary of economic projections. The dot plot indicated that 12 of 16 participants are forecasting a fourth rate hike in 2018 and 11 of 16 expect three rate hikes in 2019, which would lift the range on the federal funds rate to between 2.75 to 3 percent roughly one year from now. The committee expects the median federal funds rate of 3.4 percent in 2021.
The major takeaway from the statement was the surprise removal of the word “accommodative” from the statement, and is a major step forward by the central bank to prepare market participants and the public for the day when policy becomes restrictive. However, the combination of the statement and the summary of economic projections does create a bit of uncertainty over where the real neutral rate actually is. We are not in agreement with the Fed’s assessment that the policy rate will remain at neutral over the next two years. Our model of the Fed reaction function implies that 2.86 percent represents the upper boundary with any policy rate above 3 percent restrictive. We expect a major effort by the Fed over the next three months to explain the estimation of when rates become restrictive, even if Chairman Jerome Powell is uncomfortable with that monetary policy discussion.
The Fed, as expected, lifted its forecast of 2018 growth to 3.1 from 2.8 percent and lifted the growth rate forecast in 2019 to 2.5 percent. The central bank also lowered its unemployment rate forecast to 3.5 percent in 2019 and it anticipates that will hold through 2020 and then increase to 3.7 percent in 2021.
While the year ahead in the policy landscape faced by the FOMC should be rather quiet, excluding the risks associated with an intensifying trade spat and the external sector, the challenge that lies ahead is shaping market expectations for a turn to restrictive policy in the second half of 2019. The Fed expects inflation to hold between 2 and 2.1 percent over the next three years.
Our estimate of the Fed’s reaction function implies that the central bank will lift the federal funds rate from its current range of 2 to 2.5 percent to 2.75 to 3 percent one year from now. Based on our estimate of r* (.86) and NAIRU (3.5 percent), a setting of the policy rate above 2.86 percent represents the upper boundary of what should be considered neutral. Both policymakers and investors should note that small and medium enterprises, which have been the primary drivers of growth and hiring during the cyclical expansion, do not generally have access to the deep and broad capital markets that large firms regularly tap. These smaller firms are heavily reliant on marginal or nonbanking lenders, thus an inversion of the yield curve accompanied by a move in the federal funds rate above 3 percent in 2019 will result in restrictive policy and financial conditions for small and medium enterprises. From our vantage point, the Fed should proceed with caution as it lays the predicate for a shift in its language and forward guidance.