According to Chair Yellen’s March 15, 2017, press conference opening statement[1], a modest increase in the federal funds rate is appropriate due to:
- the economy’s solid progress toward FOMC’s goals of maximum employment and price stability and
- a delayed scale back of some accommodation could potentially require rapid rate increases in the future and risk disrupting financial markets and pushing the economy into recession.
Data Dependency
The economy continues to expand at a moderate pace. Solid income gains and relatively high levels of consumer sentiment and wealth have supported household spending growth. Business investment, which was soft for much of last year, has firmed somewhat, and business sentiment is at favorable levels. Overall, FOMC continues to expect that the economy will expand at a moderate pace over the next few years.
Job gains averaged about 200,000 per month over the past three months, maintaining the solid pace witnessed over the past year. The unemployment rate was 4.7 percent in February, near its recent low. Broader measures of labor market underutilization also remain low. Participation in the labor force has changed little, on net, for about three years. Given the underlying downward trend in participation stemming largely from the aging of the U.S. population, a relatively steady participation rate is a further sign of improving conditions in the labor market. FOMC expects job conditions to continue strengthening somewhat further.
Core inflation has changed little in recent months at about 1 ¾ percent. FOMC expects core inflation to move up and overall inflation to stabilize around 2 percent over the next couple of years, in line with FOMC’s longer-run objective.
Forward Guidance
The expected ongoing strength in the U.S. economy warrants gradual increases in the federal funds rate over the next few years to a lower neutral rate[2], which is expected to remain below levels that prevailed in previous decades. The FOMC projects the federal funds rate at 1.4% by yearend (i.e. 2 more rate hikes this year), 2.1% by yearend 2018 (i.e. 3 rate hikes next year) and 3% by the yearend 2019 (i.e. 3 to 4 more rate hikes). The economic outlook is highly uncertain, and changes in fiscal and other policies could potentially affect the outlook. March is one of the four meetings where the FOMC releases their Summary of Economic Projections and discloses their member’s projected appropriate monetary policy path forward (i.e. the dot plot).
The following table summarizes the position of the 17 members for the most recent two Economic Projection releases (i.e. December 2016 and March 2017 meetings).
The table shows the range of projections for the average federal fund rates through 2019 and in the “longer run”. Although the range of projection for each year has remained unchanged, there is a clear sign that more voting members are moving towards a higher rate regime (the darker color within each band.) For example, the March meeting shows that there is a clear movement toward a higher rate by the end of 2017. Three more members projected the rate to be at 1.375 and one more at 1.625 rate. This trend is also true for 2018 and 2019. Further, the “longer run” neutral rate appears to be steady at or around 3%. Assuming the long term projection of inflation remains at or around 2%, this means the FOMC is expecting a real neutral rate to be at 1%.
Future vs. the Past
The economy, labor statistics and inflation have changed little since the December 2016 and January 2017 meetings and yet 9 of the FOMC voting members agree to hike the federal funds rate by 25bp with Nell Kashkari voting against the action. Chair Yellen maintained that the economy is growing at a 2% to 2.1% rate, the unemployment rate is near or at NAIRU[3], and, with increased confidence, the inflation target of 2% is within sight. But the current economic data cannot alone justify the rate hike decision. Then the question is about soft data or forward looking data. For example, during the question and answer section[4] of the press conference, Chair Yellen acknowledged that consumer and business sentiment data have improved. But there is not yet evidence that sentiment has impacted spending decisions, and the timing, size and character of the new administration’s fiscal policy changes remain uncertain.
So if the current data has not changed much since December and January and the future policy changes are uncertain, FOMC’s decision to raise rates must be predicated on additional factors. We believe that the decision to hike in March is to begin rate normalization sooner when the economic conditions seem reasonable and the impact of a rate hike is expected to be somewhat benign on the financial condition. This allows the FOMC to lower the chances to have to raise rates at a much faster pace later and choke off economic growth. Moreover, the FOMC would like to restore its policy toolkit in response to the next recession.
Conclusion
The FOMC raised rates in its March 2017 meeting by 25bp based on the continuing strength in the labor economy and the gradual return of inflation to the 2% target. Moreover, the FOMC is looking to a slightly faster normalization pace than the once per year rate hike since 2015 to restore its policy toolkit sooner and to not have to substantially increase the pace if the economy turns too hot. Nonetheless, the rate normalization pace will remain gradual by historical standards to reach the terminal neutral rate of 3% in the long run. For now, the FOMC is expected to be on track for two more hikes this year.
This commentary is for informational purpose only. Opinion expressed herein should not be relied upon to make any financial or investment decisions or to make any changes to your financial condition.
[1] https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20170315.pdf
[2] The interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even kneel
[3] The non-accelerating inflation rate of unemployment and refers to a level of unemployment below which inflation rises
[4] https://www.federalreserve.gov/monetarypolicy/fomcpresconf20170315.htm